American Enterprise Institute

March 29, 2007

[Edited transcript from audio tapes]

1:45 p.m.	Registration
2:00	Introduction:	Peter J. Wallison, AEI
	Presenter:	Howell E. Jackson, Harvard Law School
	Discussants:	Ronald Gould, FSA
		Melanie L. Fein, Law Offices of Melanie Fein
		Heidi M. Schooner, Catholic University of America
		Thomas H. Stanton, Johns Hopkins University
	Moderator:	Peter J. Wallison, AEI
4:30	Adjournment

Proceedings:

Peter Wallison:  Let me welcome all of you here.  I’m Peter Wallison, a senior fellow here at the American Enterprise Institute.  This is the second in a series of conferences that we are running on the organizational structure for financial services regulation.  A third conference incidentally on this subject is now scheduled for April 20 and will cover the interim report of the Committee on Capital Markets Regulation that came out at the end of November.  That will be a full-day conference, so mark your calendars.

In recent months, including this report from the Committee on Capital Markets Regulation, there have been several reports suggesting that excessive regulation and litigation are impairing the ability of the United States to compete with other financial centers.  The competitive financial center most often cited is London, and much of London’s success in attracting financial activity from the United States has been attributed, probably too simplistically, to the relatively light regulatory hand of the Financial Services Authority (FSA).

In today’s conference, we will look at how the FSA actually functions and probe the real differences between its regulatory focus and that of U.S. regulatory agencies.  This will provide some perspective I hope not only on the FSA but on our own system.  We in the United States frequently boast that we are the home of entrepreneurship and economic freedom, that we welcome the animal spirits that energize capitalism. 

Well, maybe that is true in other areas of our economy but as we will see in the course of today’s discussion, when compared with other countries we devote more resources per capita to the regulation of financial services and we expect a greater range of protection from our regulators than many other developed countries, including the United Kingdom.

The FSA is a single agency that regulates banks, insurance companies and securities firms.  One of the reasons for regulating all three members of the financial services industry in the same agency is that they compete with one another and it makes little sense to have three competing industries all regulated in different ways.  So one reason we might admire the structure of the FSA is that it eliminates the problem of differential regulation among three competing industries. 

Yet there are also issues associated with how the FSA proceeds that would make it difficult to achieve the kind of singular, unique, individual agency for all of the operations of our financial services industry in the United States.  For example, the scope of regulation in the United States is quite different for each of the members of the financial services industry.  For the most part, banking regulation is oriented toward safety and soundness, the prevention of systemic risk and the protection of the deposit insurance funds.  Securities regulation, on the other hand, is primarily focused on consumer protection with little overt concern, except insofar as it becomes a consumer protection issue, about safety and soundness.  Insurance regulation is somewhere in the middle.

Is there a way to reconcile all these different approaches to regulation?  The FSA structure addresses this problem by dividing its structure along functional lines – not by industry (that’s the way we tend to think of functional here in the United States) but by the kind of regulation that is required.  Accordingly, if there were to be a similar consolidated structure in the United States, the agency would have a division that is concerned with safety and soundness and another division that is concerned with consumer protection.  In both cases, that would be true for all three industries.  This is one area where FSA organization is instructive and useful if we think about a reorganization in our own system.

A second major difference is the enforcement orientation of regulation in the United States, particularly at the SEC.  The FSA’s approach for all industries it regulates is much closer to the way banking agencies in the United States deal with banks.  It is prudentially oriented, with a bias in favor of guidance and quiet resolution of compliance issues rather than a public charge and eventual litigation.  This is not only a cultural difference that would be difficult to bridge but there is also a question whether these staff-intensive kinds of procedures could be followed by a U.S. agency that is trying to regulate 10,000 banks, 10,000 investment advisors, 6,000 securities firms and 660,000 registered securities sales personnel.

Another major difference between the FSA and the United States regulatory structure is the focus on consumer protection.  Although consumer protection is one of the priorities of the FSA, it does not seem to assume the same priority for the FSA that it has for U.S. regulators.  The enormous controversy associated with the Comptroller of the Currency’s attempt to preempt state consumer protection laws under certain circumstances, partially to protect the safety and soundness of banks, demonstrates how important this issue is in the United States and how difficult it will be to reconcile these differing and occasionally inconsistent objectives within the same agency.

This raises an interesting question.  Many of the issues that have been cited as reasons why foreign companies are reluctant to enter our markets are consumer protection issues, including the Sarbanes-Oxley Act, the aggressive enforcement approach of the SEC, and the risk of becoming a defendant in a costly private class action.  If these turn out to be serious obstacles to the participation of the United States in the global securities market that is now in the process of developing, we might anticipate a serious clash in the future between the consumer protection culture in the United States and a demand from the rest of the world for less regulation as a condition for entering our markets. 

It seems likely to me that this important issue, if it arises, will not be resolved through a substantive change in regulatory policy.  Rather, it will be resolved through a change in regulatory structure with an explicit or implicit understanding that the new regulator or regulators must consider the competitiveness of the U.S. financial services market when making regulations.

That leads to another difference between the United States and the FSA’s regulatory structure.  At one point in the not-too-distant past, regulatory agencies were charged with promoting the industries they were responsible for regulating.  The Federal Home Loan Bank Board, which regulated savings and loan associations, had exactly this statutory mandate.  It was a promotional as well as a regulatory mandate.  When the S&Ls collapsed, the huge losses to taxpayers resulted in one major lesson, in addition to some substantial reorganization of that organization.  That lesson was that regulatory agencies should not have any responsibility for promoting the industries they regulate, except for maintaining the safety and soundness of constituent institutions. 

So it’s noteworthy that the FSA has a specific regulatory goal not to promote regulated industries but rather to maintain London as a leading financial center.  It’s difficult to see how this is different from promoting the financial services industry, but if in the future the competitiveness of the U.S. market becomes a dominant issue, Congress could well authorize one or more U.S. regulators to consider the effect of their regulations on the competitiveness of the United States in the global financial services economy.  In that case, it will be very important to understand how the FSA actually operates in this area.

Finally, Howell Jackson raises a point in his paper that he doesn’t resolve but which is certainly worth thinking about.  The differences in resources devoted to regulation of the financial services industries in the United States and those devoted to similar regulation in the UK and elsewhere are so striking that it begs the question, which of these jurisdictions has got it right?  There is probably an optimum point for regulation, a point where the tendency to promote confidence among market participants is in balance with its tendency to drive away those who would be regulated.  If that’s true, either we or they are following suboptimal policies.

One way to look at the migration of financial transactions away from the United States is that the market is telling us something – principally, that the overall benefits of regulation in the United States are no longer equal to the costs.  If so, it provides a practical way to judge whether this country’s regulatory system is too lax or too heavy-handed.  The migration of financial transactions from the United States to the United Kingdom suggests that it is the United States that has the suboptimal system.  If this idea takes hold, it will be important to understand how the FSA does its work, and that’s the reason for the conference today.

I’m going to introduce each of our participants, each of the people on the panel, as they are about to speak.  The first person who I will introduce is Howell Jackson.  Howell is a professor at Harvard Law School.  He’s the James S. Reed, Jr. Professor at Harvard Law School.  One of the reasons he is here today is he’s been on a nine-month sabbatical in the UK studying the FSA, and not just the FSA but also the regulatory intensity, if I may call it that, that a number of countries use in regulating their financial services industries. 

His research interests include financial regulation, international finance, consumer protection, federal budget policy and social security reform.  He’s served as a consultant to the U.S. Treasury Department, the United Nations Development Program, the World Bank and the International Monetary Fund.  He’s a co-editor of several books, including Fiscal Challenges: An Interdisciplinary Approach to Budget Policy.  He’s a co-author of Regulation of Financial Institutions, which was published by West in 1999, and a number of other books and articles.

I should mention that for every one of the very distinguished people on the panel today, there is a very complete biography in your materials and I hope you will refer to that.  I’m just going to mention some of the highlights.

Howell Jackson:  [initial remarks off-mike]  Thanks very much.  It’s a pleasure to be here in Washington today and with the panelists, many of whom are old friends.  So I’m going to talk a little bit about my paper that’s in your packages--it comes not out of my current sabbatical but out of my last sabbatical, which was in 1999.  I had been just previously working for the Treasury Department on the legislation that became the Gramm-Leach-Bliley Act, so I’ve been working on financial modernization here.  When I left, it looked like the legislation was stalled and not going anywhere.  Once I left it passed, so I didn’t have much to do with its passage.  But it did make me quite interested in what was going on in the UK at the time, which was the creation of the FSA in 1999 through 2000 and 2001 – the formative years. 

I know people in this room are aware that regulation in the United States that we deal with, teaching and practicing, is complicated.  There are many agencies.  There are agencies at the state level, there are multiple agencies at the federal level, for banking, securities and insurance.  There’s the CFTC and a host of other organizations.  So it’s clearly complicated and multi-faceted. 

So I was impressed when I got to England, and that is the box that was being presented to me of the Financial Services Authority.  The first thing I should say is that’s not really the complete box.  There are a bunch of other, little things that are going on in the UK.  Insurance standards.  Fair trading, which does a fair amount of consumer credit stuff.  Occupational pensions are partially outside of the FSA.  On the corporate law side, the Department for Trade and Industry (DTI) does a certain number of things.  There’s auditing and accounting that’s elsewhere.  So it’s not a fully consolidated system but it is much more consolidated and it did bring together the three core industries that Peter referred to in 1999-2000, from roughly a dozen different agencies that were in operation beforehand.

I think it’s sort of worth understanding how that came to pass, particularly in that at roughly the same time in the United States with the Gramm-Leach-Bliley Act, there was maybe one effort to get the SEC and the banking and insurance agencies together in a council that might meet periodically to discuss policy.  That lasted about 24 hours before it was shot down as an idea.  So there was zero regulatory consolidation with Gramm-Leach-Bliley.  There’s been a little bit on the deposit insurance side since then but really more or less, we’ve had a relatively stable regulatory structure, if anything adding the Public Company Accounting Oversight Board (PCAOB)--a major new federal player.

So why did that happen?  What’s different in the UK and the United States?  I think it’s important to understand.

By way of background, there were some financial crises in the London markets. Barings, BCCI were sort of banking failures, major institutional failures.  There was also a pension fraud scandal associated with Maxwell Interests that had a consumer protection flavor to it.  So there were things in the background that made certain members of the public and the politicians feeling that some kind of regulatory reform was necessary.  However, I think it’s really important to focus on the parliamentary system of government in the UK, that when Tony Blair came in with the new government he could push together a legislative program and get it enacted in a way that it’s kind of difficult to imagine in the United States.  So that kind of core difference in terms of having regulatory reform is important to note.

There also were other things going on that made it somewhat easier to do regulatory reform in the UK.  One of those things is the EU.  The EU was moving towards internal markets.  It was adopting directives that I’m sure many of you have heard about.  The directives forced certain kinds of legislation to be adopted in the United Kingdom.  So for example, one of the requirements of the European directives was that review of listings on the exchange be done by a statutory regulator as opposed to a self-regulatory organization.  So certain things had to move from the traditional structure of self-regulation in the securities industry into more statutory regimes.

The British had already started this process in 1986, moving things away from a completely self-regulated environment to a series of hybrid organizations.  So the process had already begun but it was accelerated by the European Union.  The Human Rights Convention, which is associated with the European member states, is a kind of due process requirement that was being imposed on the UK at the time, which required some attention to administrative procedures too, also necessitating change.  But it was sort of – change was in the air and I think that made a difference.

There was also a willingness to approach regulation and regulatory change that is really dramatically different than what you see in the United States.  The initial skeletal legislation had a lot of holes in it.  There were a lot of secondments of people from the Bank of England and other agencies to go to the FSA before their statutory mandate was worked out.  It’s hard to believe in this country that we would send officials somewhere without clear statutory mandates, or if we did try to do it, there would be litigation the next day to stop it.  There was much more in the UK structure a willingness to muddle through, a willingness to try to work things out, and actually in the process a number of very sensible accommodations. 

One accommodation which I mention in the paper is that the British authorities basically committed to keeping the personnel on of all the agencies for a transitional period.  So one thing that was taken off the table, at least in the short term, was loss of jobs for regulatory personnel.  There were also a variety of experts to kind of bring the organization together and work things out.

The other thing that I think contrasts the UK perspective, and this is something that Peter has alluded to a little bit already, is quite a different perspective on their relationship to the world and a common understanding that there is something in the national interest of keeping the United Kingdom and particularly London a financial center.  In the late 1990s, the European financial centers, particularly Frankfurt, and to some degree Paris, were on the rise.  England wasn’t coming into the Eurozone.  There was a concern that that might disadvantage the city.  So there was a sense that they needed to do something to make sure that the city maintained its preeminence. 

And also part of the cosmopolitan perspective – there was a notion that maybe not everyone at the FSA should be British.  That’s definitely the case, and I’m not just talking about Northern Irish and Scottish.  There are many people from many different jurisdictions who work at the FSA and are rotated through its senior levels, which makes the agency feel quite a bit different than what you see sometimes in the United States.

One way you can sort of get a handle on the differences in regulatory philosophy is looking at the statutes themselves, particularly the statutory goals of the FSA, and compare them to the United States.  I’ve written previously on what the United States is up to in its regulation, and I won’t go into detail here except to say in my own view the most important thing for us is protection of depositors and investors – investor protection, consumer protection is a primary goal for the United States.  Obviously the reduction of systemic risk, externalities, is a goal, so that’s kind of also quite important, particularly important for banking.  I would say just a little bit, to disagree with Peter, even on the securities side, when you think about market breaks, market crashes, there are concerns – if you think about hedge fund regulation – those are systemic concerns again on the securities side.  So it’s definitely prevalent.

What’s really distinguishing about the United States though, compared to the UK and other countries, is we try to do a lot of other stuff with our regulatory structure.  We have redistributive and social policies that are in place in our financial regulation.  The Community Reinvestment Act is certainly a good example of that but it’s not the only thing.  We have lots of requirements in insurance law that state insurance companies reinvest with state authorities. There’s a variety of equalization policies that we have – that all shareholders be treated equally.  So we try to do more things with our regulation than other countries do.

We also have a political economy view about our regulatory structure that’s different than other jurisdictions. For example, having state presence in both banking and securities and insurance regulation is quite pronounced.  The desire to break up the regulatory structure into different pieces, sort of a vision of separation of powers as well as federalism, is strong and it influences what we do.  Maybe we shouldn’t be doing these things, and I know some people on this panel probably think we do too much of these latter things. But we definitely do some of that in our regulatory structure.

If you go over to the FSA, what you see in their statute is four objectives.  These are not just in the statute, they organize what the FSA does.  When they have their annual reports they speak in terms of the statutory objective.

The top objective, maintaining confidence in the financial system, is kind of a systemic risk concern.  That’s their top mandate.

Their secondary mandate, interestingly, is promoting understanding of the financial system – a consumer education mandate.  You can see that in the United States.  If you go to the Department of Labor, on the pension side they sometimes do that.  The Fed has a consumer education group.  It’s no way number two in the United States but it is a number two objective for the FSA.

Their consumer protection objective, which is the third, I’ve underlined the word that I think is key – appropriate degree of protection for consumers, as opposed to absolute.  If you talk to our regulators and look what they do, it sometimes seems that complete protection is the goal.  The FSA quite explicitly has an appropriate protection. 

Financial crimes is also the fourth objective, to prevent financial crime.  You can definitely see that in the United States, obviously more so after 9/11.

Beyond the statutory objectives, I won’t go into this too much, but in the statute they also, to give the regulators more guidance, have principles of good regulation about how the FSA is supposed to proceed.  Several of these have to do with cost-benefit analysis – resources are effectively used, responsibilities of management – in other words, put the burden on financial firms’ management to do things rather than on the regulators.  That’s a principle of good regulation for them and it does show up in what they do.  Proportionality between burdens and benefits is also cost-benefit analysis.

It’s quite striking to go to the FSA website and look at their discussion of cost-benefit analysis.  They’re constantly doing it.  They’re constantly commissioning white papers on it.  They’re constantly trying to understand the incremental costs and benefits of their regulation.  There’s a very interesting article coming out in the Stanford Journal on Business and Finance, comparing to some degree the SEC’s approach to cost-benefit analysis, which of course has been in litigation recently, with the FSA’s.  There is definitely a difference in what you would see.

The other principles of good regulation I would just summarize quickly.  To me, they reflect the competitive concerns of the UK, worrying about innovation – they even have in the statute the desirability of maintaining the UK’s competitive position.  You occasionally see competition in U.S. financial regulation goals but it’s sort of making sure the industry is competitive, the Bank Holding Company Act, competitive analysis.  You don’t usually see – let’s keep New York number one in a statutory mandate in the United States, whereas that’s precisely what you see there.

So the goals are quite different.  As Peter mentioned, this is reflected in a lot of different ways.  One interesting way it’s reflected – and Ron, who’s actually working at the FSA, can speak to this – the organizational structure of the FSA has a chairman and then a bunch of branch offices like the general counsel that are providing support.  I don’t have them all up there, but the Personnel Office, Enforcement, General Counsel, Strategy and Risk – that’s a kind of risk assessment office.  Interesting is the enforcement office is kind of a staffing office.  It has roughly 8 percent of the personnel at the FSA.  At the SEC enforcement has 40 percent of the SEC’s personnel. So just a slightly different weighting.

Some of the other panelists might mention, but Margaret Cole, who is the head of this office, just gave a speech up at Fordham this year called “Nobody Does It Better.”  She was plugging, I think, the Bond movie series, but she’s also plugging their enforcement approach, which is the light-touch approach.

Substantively, this is what Peter was alluding to – how the FSA’s main divisions are broken up is not the familiar insurance, banking and securities.  You can see FSAs that look like that – the Japanese one, I believe, has our kind of institutional structure.  Here they have the retail markets one, which is kind of conduct of business, dealing with consumers, consumer protection type stuff.  Wholesale and institutional gets to systemic risk issues, prudential issues, as a kind of functional mandate.  Regulatory services does a bunch of things but I believe the authorizations is still in there. So when you want a license to do stuff in the UK, you just go to the regulatory services and get your insurance or deposit-taking or securities license.  You don’t have to go to fifty state regulators and the OCC and whoever else.  You go to one-stop shopping there, which is an attractive feature.

I think this approach reflects the mandates.  On the retail side, a lot of work is done on conduct of business, putting out to the companies the responsibility to work with consumers in a fair way.  Much less rule requirements, much less detail, more imposition on management to work things out.  Then on the systemic risk side, what they’re doing is looking carefully at the economy to see where the risks are and triaging the financial services sector, focusing where they think there are genuine risks of a systemic sort.  That means they don’t do comprehensive regulation of the kind that we do in this country. So one of our regulatory goals here is to examine everyone within a period for, say, banking. That’s not the FSA’s approach.  If they think small banks are not much of a risk, they won’t necessarily inspect them on a regular basis. 

I’m sure Ron will talk more about the structure but let me just push on to regulatory intensity, since I think in some ways this is what I’m currently working on.  It’s also interesting to understand the FSA.

I have been looking at regulatory intensity for a while, particularly in the United States where we have a lot of regulatory agencies doing a lot of different things.  The bottom line in the United States, just to give you a little metric, is that we spend about $6 billion a year on financial regulation and employ something south of 44,000 people in banking, insurance, securities and pensions.  So $6 billion, 44,000 employees.

The FSA, in comparison to this, is much smaller.  So when someone talks about consolidation here, the FSA currently has about 4,000 people.  At the point of consolidation it was about 2,500-3,000.  So less than 10 percent of the numbers that’s involved.  So it’s a much smaller agency in absolute terms.  So if you want to imagine a consolidation of 43,000-44,000 in the United States, it’s just a whole different kettle of fish.

This is kind of scaled in a different way, pulling out the pensions and a little bit in the past, but this is the United States regulatory personnel compared to other countries around the world.  Not scaled to the size of economies or anything.  There’s lots of reasons why you might expect the number to be different.  But if you go to international financial organizations and sort of have the feeling that there are a lot of Americans around, that’s the reason why.  There’s just a lot more Americans in this business to go overseas and do stuff.  There’s many more compared to the UK. 

We’re going to be doing this UK-US discussion here.  The UK, after the U.S., is a pretty big regulatory agency.  So if you want to talk about Germany or France or some other places, they’re much smaller.  The UK is relatively closer to us and we can talk about that if you want to.

Where does the difference come from?  What I’m doing in this chart is scaling sectors.  The biggest sectoral difference between the U.S. and the UK is actually on the banking side.  So if you took banking regulators across the banking regulation and divide by banking assets, that’s where we’re really expensive.  We have this very elaborate system of multiple banks, lots of examinations.  Peter mentioned that we don’t do much sanctioning on the banking side but actually if you look at our bank sanctions, there are quite a few of them compared to the UK.  There’s also a big sanction differential.  I’ll show some data about securities in a second but banking is quite different.

Insurance, we are also bigger.  Some of the smaller countries like Hong Kong and Singapore, it’s hard to do the comparisons. But we have more people again in insurance and overall regulation, when you take our regulatory costs and you normalize them for the GDP or you normalize them for the population of the country, this chart shows regulatory staff per million of population.  This is the bottom line that we are employing many more people, twice the number in financial regulation oversight, than the UK and many times that more than certain other jurisdictions.

This is particularly striking because there’s a lot of evidence that there are economies of scale in financial regulation.  So we are A) not taking advantage of our economies of scale; and B) doing something else.

This is evidence of regulatory intensity, which is one of the issues we’re going to talk about.  To the extent that we’re talking about consolidation and could the U.S. consolidate, amongst other barriers there is a scale barrier.  There’s no country in the world that would have an FSA that approaches the size that our consolidated supervision of existing U.S. operations would have.

The other point that was alluded to beforehand, and let me talk you through this slide which has probably too many small numbers for you to read, but this is a summary on the securities side of how many securities actions are brought in the United States each year.  The period I’m looking at here is 2000-2004.  What this slide shows is that there are an awful lot of actions in the United States.  Roughly speaking, 3,600 public actions, about one-sixth of them by the SEC, then a lot of NASD and NYSE self-regulatory actions brought against private parties of various sorts, a whole bunch more at the state level – those are estimated because the data isn’t very good at the state level.  So about 3,600 times a year during this period, some formal regulatory action is taken against some individual, some company, some firm.  On top of that, there are a substantial number of private actions.  The largest number are securities arbitration actions – NASD or NYSE – though in monetary terms class actions, which are roughly 200 a year, are the bigger ticket item.

In terms of sanctions and penalties imposed on individuals in the United States, the public sector in this period imposed a little bit more than $5 billion worth of sanctions on private companies.  Then if you put in securities litigation, there’s another about $3.5 billion of securities claims and arbitration.  So we are sanctioning people in the United States at the $8 billion a year level on average. 

So in terms of regulatory cost in the United States, you could say there’s that $6 billion of direct costs of keeping the regulators in operation and then these sanctions are out there too.  They’re a little bit different than direct costs because in some sense they’re like taxes.  But that just gives you a rough idea of what our regulatory apparatus is up to.

If you compare this to the UK, the most striking thing is the piece down here of the private securities litigation just is not present in the UK.  The UK does not have a securities litigation process that’s anything like ours.  They do have public oversight though.  Here are the summary statistics from the previous chart.  In the United States we do 3,600 sanctions and impose about $5 billion in penalties.  In the United Kingdom for this period, this is 2004 and after that it’s a little higher than earlier, 2002-2003, roughly 90 sanctions and $40 million worth of public penalties imposed.

So we’re now talking a couple of order of magnitude difference in amounts.  Germany, which is also on this slide, has slightly more actions but the penalties are probably lower.  That data is not available.  If you want to scale this, we can ignore Germany on the left but just the United States and United Kingdom, in terms of public sanctions per trillion dollars of market capitalization – sort of how many actions there are – we are really bringing a lot more actions against our companies from our public authorities.  If you look at the sanction numbers, the differential is even greater, scaled for the size of the economy.  So there’s really quite a difference of regulatory intensity on the sanctioning sides here.

I should say in doing this there’s a couple things that are clear.  The size of the agencies, the commitment to enforcement, the amount of enforcement actions and the penalties, are clearly quite different.  One has to be a little careful making comparisons.  There are certain things that the FSA does that is different.  They use informal guidances, they use informal interventions in a way that we don’t.  So one has to be aware of that.

So for example, if you read the SEC’s annual report, they brag that 90 percent of their actions result in victories for the SEC – 90 percent of their investigations result in a favorable outcome to the SEC.  If you read the FSA’s annual report, they brag that 60 percent of their investigations were resolved without formal actions.  So they think it’s a good thing to resolve things without formal actions.  They often get parties to settle, pay money, hire skilled advisors to do investigations on the informal side and never have the settlement.  So while the SEC and U.S. authorities are trying to collect data on the number of actions, the FSA has a slightly different attitude.  So just looking at the formal numbers can be a little bit misleading.

There’s also certain things that go on in the UK in different places.  So for example, the corporate finance SEC function of inspecting corporate financial statements for accuracy with U.S. GAAP, compliance with U.S. GAAP, is done by a different body in the UK.  So that part of corporate finance is not fully replicated in this data.  So one needs to be careful. 

I think even when one is careful, there is a genuine difference between regulatory intensity.  Certainly it’s true on the private side.  I think it’s also true on the public side, as the data that I have.

There’s also some interesting differences.  In the United States we often report very high public sanctions that can’t be collected.  So in one year, I think 2002, the SEC only collected 40 percent of its public sanctions and penalties because the people were bankrupt.  The FSA won’t impose a penalty if it drives you into bankruptcy.  So the meaning of their numbers are a little bit different.  Even aside from that there is real differences here.

Peter is right – in the paper that was circulated to you, I don’t opine as to who has got it right.  I have subsequent papers that also don’t opine about who’s got it right because it’s really difficult to know which system is right. 

One thing that is important to bear in mind is what is the compliance ratio?  How many violations are out there?  How much chicanery is going on?  We don’t know that really.  It’s hard to know.  It’s possible in the United States, with all of our entrepreneurial zeal, we encourage people to go for it, to push themselves, and some fraction of our citizens may misunderstand that instruction, which is to go for it by whatever means.  So it’s conceivable that we have a dynamic economy that requires stronger regulation.  So it’s possible that we both have it right – possible.  But these numbers are certainly worth pursuing.

Some recent developments.  My perspective, having been back in the UK this year, certainly risk-based regulation, attention to where the risks are and focusing resources with cost-benefit analysis, is going on.  There is also I think a little bit of change in the FSA going on.  There is getting to be a little bit of Americanization of the FSA over time.  Their procedures are getting slightly more formal, with the regulatory decisions committee, which is an internal panel that was converted.  Their staff has been growing.  It’s gone from under 3,000 to close to 4,000. 

One interesting piece of the staff that’s really grown a lot, almost a quarter of their staff is in something called the ombudsman service, which is a consumer complaints service that handles consumer complaints, works out settlements, does quite a bit of work and gets a fair amount of resources.  If you look at the FSA’s public statements – Margaret Cole, who gave the speech in New York I mentioned – there is a sense from some officials that they should be doing more criminal prosecutions.  They’ve had relatively few.  I think the FSA has referred two criminal prosecutions in the last couple of years, a very small number compared to the United States.  There’s also just been a report from the Treasury about what kind of litigation should they have on the securities side.  Clearly they haven’t decided to go towards litigation but at least it’s on the table, and with some EU directives that are forcing them to look at that issue.

The other thing I would say that continues to distinguish the agency in my view is there’s still a lot more collaboration between the FSA and the financial services industry in the UK than what would be familiar to us in the United States.  The FSA itself has an annual report with an annual meeting as if they had shareholders.  They don’t really but they sort of behave as if they are responsible to the industry in a way.  There’s a lot of use of external advisors and committees to get input of various sorts.  I think that’s more active.  It’s a little bit of a legacy of the old City, of self-regulation.  Even though they’ve clearly moved to a statutory structure, there is a little bit more connectedness to the industry. 

I think one important thing about the FSA to understand is where is the FSA?  I actually had the wrong building initially but Ron corrected me.  There is the FSA, at Canary Wharf.  That’s the old Docklands that’s been completely rebuilt.  That’s the north colonnade.  The thing that’s interesting is that’s Citigroup, that’s Hong Kong Shanghai Bank, that’s Barclays, that’s Clifford Chance, which is the biggest law firm in the UK, that’s Reuters. 

This is all the financial services sector core offices are very close to the FSA.  They’re much more connected.  I tried to get a Google map of the SEC’s new headquarters.  Apparently it’s not interesting enough to Google to have nice pictures of.  But what’s next to it?  Union Station is next to it.  There’s a couple of parking lots.  It’s 500 miles, or however far New York is, to the biggest firms.  This is just an organization that has a different relationship to the financial services industry than we have in the United States.

One of the issues on the table here is are these differences driving what we observed or what people have talked about, which is financial business moving to London – in particular, issuers choosing to raise capital in London rather than the United States.  That’s an interesting question.  I would say to some degree this must be in effect but there’s a lot of other things that are going on here.

I did a study in 2001 on capital raising.  The rise of the 144A market, the way of getting U.S. capital – it was already changing before SOX was in place.  The European capital markets were developing.  Institutional investors were already there.  The market professionals, the accountants, the investment bankers were already there.  So there were things outside of regulation that were centering business in London.  I think the rise of European capital, the importance of the Eurozone as an alternative to the dollar.  London has managed to be the center of that, surprisingly to some.  Russian money – a lot of petrodollars that used to come to the United States are going to London.  There are lots of things that are contributing to the current success of London.  SOX may be a piece of it but it’s clearly not the whole piece, in my view.

Peter Wallison:  Thank you very much, that was quite interesting.  Let me just mention something I forgot to mention before, and that is I hope you will all keep track of questions that you might have for the various speakers because we will have question opportunity at the end.  Also, Howell’s slides, which we didn’t reproduce for you, will be posted on our website after this meeting so you’ll be able to download them and see some of those tiny numbers that he was talking about.

Howell, I just have one question about the consumer protection work that the FSA does.  You showed 90 sanctions between 2002 and 2004.  That’s not an average, that’s accumulative –

Howell Jackson:  That is an average.  The average is actually a little lower, that was the 2004 figure I put up.  But it’s sort of in the 70 to 90 actions.

Peter Wallison:  How much of those are consumer protection actions?  Can you break those out?

Howell Jackson:  Yeah, I’ve looked at it.  The answer is a fair number of them would be conduct of business, pension and insurance sales scheme problems.  There are clearly some market abuse insider trading sanctions in there that are on the market side.  There are just a handful of listing sanctions.  They are spread over a range.  It’s all in the FSA annual reports each year. 

The thing that’s kind of interesting is you don’t see any banking – hardly any banking sanctions in there, the truth in lending sanction type things or capital directive type sanctions.  But the area that has continued to be sort of the consumer problem has been the pension insurance selling structures.  That’s in the popular press.  If you go to the UK right now and ask a person on the street what they think about the FSA, they will say, “Tut, tut, tut... pensions and insurance, they should have caught those things.”  That’s where they’re getting public flak.  So that’s where some of the sanctions are.

Peter Wallison:  And the $40 million, is that an average per year?

Howell Jackson:  That was the 2004 number.  It’s a little bit lower on average.  It’s dominated by two big sanctions against major intermediaries.  It’s one Citi and one Swiss – Ron probably would remember this.  But that’s more than half of it and then there are lots of small things.

Peter Wallison:  Those are not consumer protection?

Howell Jackson:  The consumer protection ones are smaller numbers.

Peter Wallison:  Even smaller than that?  Because $40 million divided by 90 starts it out pretty small.

Howell Jackson:  By U.S. standards.  Again, Peter, one of the things you have to understand is – there’s one interesting case where there was a $1 million penalty but the private party had a $100 million settlement that they made with consumers outside of the regulatory process.  So they agreed to do it.  The SEC would never leave $100 million on the table out of their figures.  But the FSA likes to be able – in some sense, they like these numbers low.  You just need to understand this.  So there’s more going on than the formal numbers show.

Peter Wallison:  Great, thank you very much.  Our next speaker is Ron Gould from the FSA.  Ron is a senior advisor to the FSA and his background is in investment management and investment banking.  He ran the international investment activities of AXA Investment Managers and was a vice chairman of the Barclays Asset Management Group.  He’s built several successful investment management firms around the world and was responsible for Barclays acquisition of what is now Barclays Global Investors.  We’re delighted to have you here and look forward to your comments.

Ronald Gould:  Thanks.  I don’t know that Howell’s excellent paper and supplementary slides have left me all that much to talk about.  I guess the first thing I should say in this distinguished group is I’m the only one who’s not a lawyer.  I think that’s great.  Second, as is probably obvious now that I’ve opened my mouth, I’m also not British by birth, although I do also carry the right passport. 

I’m one of a small group of people who act as advisors to the FSA, drawn from industry.  In a funny way, that’s not a bad example of some of the differences that Howell was trying to elaborate on.  There are lots of differences between the style and approach that you see to regulation between the U.S. and the UK but very broadly speaking this notion of connection between the regulator and the industry – and to be fair, between the regulator and consumers who consume from the industry – is a much closer, more interactive one.

I’ve got some prepared remarks which I will steadfastly, if not ignore, certainly deviate from, although I think you’ll get copies at some point if you haven’t already.  What I’d like to do is try to tread a fairly fine line between a kind of panegyric, holding up the FSA as a silly paradigm of perfection in international financial regulation, which is clearly not the case as Howell has carefully said, but between that and saying that it’s completely irrelevant from a U.S. perspective.  There’s no question that there are some approaches, some practices, some ideas that are embodied in the approach that the FSA takes that are relevant to U.S. financial markets regulation.  While I’m certainly not going to talk about all of them, I’ll try to hit a few of them and to use a few examples that with some luck will be instructive along the way.

I guess starting out, I ought to say that this idea that characterizes the FSA’s approach to the industry is probably best characterized and contrasted with that in the U.S. as engagement with industry and engagement with consumers, as opposed to what on balance – and I hope not too unfairly – I would call confrontation between regulators and the regulated firms in the U.S.  That is a philosophical backdrop that I think informs a lot of the difference between the regulatory approaches in the two jurisdictions. 

It is absolutely clear that what we spend a lot of time doing both directly as well as through trade panels and consumer panels is interacting with people who use financial services and interacting with people who provide financial services.  We do that because we are much more oriented towards outcomes, and it does come back a little bit to what Howell was saying before about sanctions, for example.  If in fact you’re oriented primarily to achieving a desired outcome, you’re actually much less concerned with whether you’ve gotten a big fine out of someone or gotten a big newspaper headline.  Instead you much prefer to ensure that your statutory obligations toward the industry and consumers are being effective in the way they’re implemented.  I think that makes a big difference in not just the approach but also what appears to the public to be the approach.  Those two are sometimes rather more different than we would like.

I think it’s probably right, just to come back to some comments that Peter opened with regarding all of the PR lately as between London and New York and as between the regulatory environment in each of the two places, and just look at some of the points raised in the Bloomberg-Schumer report, for example.  In that report, there were a few points that were made.  One had to do with the relative importance of financial services in the U.S. and most especially in New York.  Another had to do with the rate of growth of financial services both in the U.S. generally and in New York. 

I think it’s fair to say that while those are powerful figures that came out of the report, as with all figures they can if not outright lie, they can mislead a little bit.  I think it’s important to remember that while the rate of growth in financial services may rise and fall over time, the rate of growth in financial services over the last decade in both the U.S. and in New York City has been very high, about twice the rate of the overall economy’s economic growth. 

So whatever we may be talking about in terms of the relative competitive position between the U.S. and the UK, between New York and London, I think everyone should bear in mind that we’re talking about in all cases a very healthy and robust kind of growth where the issue may be about market share, and even there I would suggest it’s a little too simplistic to suggest that the high-level market share numbers are necessarily telling the whole story.

But one of the things that comes out of the Bloomberg-Schumer report is the suggestion that while the U.S. clearly has some competitive strengths and perhaps actually competitive advantages, that they are at somewhat of a disadvantage when it comes to regulation – that the regulatory burden in the U.S. is heavy as compared to the UK.  They refer to the UK regulatory environment – I think Howell may have as well – as “light-touch.”  That’s not a description that everyone at the FSA is very comfortable with, for reasons that are probably obvious.

I’d like to spend a little bit of time not debunking the flattering comments that have been made about the FSA as a regulator lately, but at least exploring a couple of them a little more so we have a more balanced picture.

The first thing I’d like to look at is this notion of the FSA as a principles-based regulator.  Howell’s been kind enough to put up the eleven principles in different pieces before.  You could put them on a little 3 X 5 card if you wanted to.  It’s 194 words, by the way, for those of you who like to collect trivia.  It does emphasize all of the key requirements that we have as a regulator.  It looks at our statutory objectives and it looks at what flows from that set of statutory objectives – what we’re required to do, including being cognizant of the competitive position not just of the UK but also recognizing the value of competition to consumers. 

It’s very easy to look at this as a kind of UK-US kind of thing.  I think it’s very easy to forget in that context that one of the reasons for the emphasis on competition is that the UK parliament recognized the importance of competition to consumers.  It was also for that reason that the references to competition were included in the principles.

Principles are a great thing and we have made a very high-profile effort to say we are moving more towards principles in our regulatory position and away from rules.  But Melanie asked me, luckily too late because I was already on the airplane, if I could bring a copy of the FSA handbook with me.  I emailed back on my trusty Blackberry to say I didn’t think my suitcase would be large enough and it would certainly be well overweight if I tried. 

To say that we are a principles-based regulator is not to suggest that there aren’t any rules.  There are today about 8,500 pages of rules, which I think you’d have to be pretty generous to suggest means that we don’t have any rules, we only have those eleven principles.  I’m certainly not going to be that generous.

It is true that we are in the process of reducing the number of rules that we have.  I think in 2007 we will probably drop somewhere between 1,000 and 1,500 pages of that 8,500-page rulebook.  But that still leaves quite a few left.  I think no one is under any illusions that the rules are going to go away. 

We also have another source of rules, which Howell alluded to, which is completely beyond our control, and that is the European Commission – where we are required to implement European Union directives.  Some of them, we’re given a few options on the nature of that implementation.  Some of them, and in financial services I have to say many of them, are what’s called maximum harmonization directives, which is a euphemistic way of saying you basically have to copy it out and do as you’re told.  We have no choice in the matter.  So there is an element of our rulebook, and not an inconsequential element of our rulebook, that we have no control over.  That’s just something to bear in mind.

We are really committed to trying to rebalance, despite the pressure on rules, between rules and principles because we think it will be a better way of doing what we do.  I’ve tried to pull out a few examples of what we have done already.  Let me just use those right now.

We have a principle that states a firm must manage conflicts of interest, both between itself and its customers and between a customer and another customer.  We recognize that in the financial services market people are always pressing to create new instruments.  The creation of new instruments is extremely important to the growth, the competition, the quality of markets.  That’s one of our statutory responsibilities.  It’s also a statutory responsibility, and one of our principles, to encourage firms to deal with conflicts of interest. 

The way we do that in the context of principles is to say to senior management of firms – look, no one knows your business better than you do.  We have a group of principles here that you need to adhere to but we are not going to give you prescriptive advice as to how to do that.  You know your business. Here are the principles.  Look at them and develop an approach which is consistent with those principles.  We’ll then come back and look at them, see how you’ve done, give you a view – possibly tell you to fix them – but it will be an interactive process, and it will be an interactive process based on their interpretation of the principles in a way which reflects their business model.  That’s pretty important.

The other area I’d like to touch on is this notion that the FSA is a light-touch regulator, partly because I think all too often we all have a tendency to translate the notion of light-touch into soft-touch.  That’s not a very comfortable feeling for any regulator.

As Howell said, we’ve a tendency not to go either for big headlines in our sanction work or for huge fines, at least by U.S. standards.  I think it’s probably important to say the U.S., for a variety of reasons, has a very high standard, if nothing else, in terms of the nominal amount involved in sanctions.  By non-U.S. standards, I think it’s fair to say that the kind of sanctions or fines that are imposed by the FSA are relatively high when we do it. 

I guess the other point to make – we were just having this discussion earlier about the nature of sanctions, the size and so on – we were in effect leaving out the judgments of what’s called the financial ombudsman service, which is where the vast majority of consumer complaints and the resolution of consumer complaints goes.  Those numbers, both numerically and in terms of fines, are not included in the figures that Howell cited before.  I suppose while we’re at it, the financial ombudsman service is not actually part of the FSA, so it tends to inflate the staff figures you were looking at as well.  Those figures have now dropped to about 2,800 people.  Interestingly for a regulator in a large bureaucracy, they’re headed to 2,500 people as opposed to the other direction.

That is also a reflection of an objective that we have from the move towards a more principles-based approach and away from a more rules-based approach, which is that we need different kinds of people and perhaps fewer of them in order to be able to engage effectively across the table with senior management of firms.  Whether we succeed in doing that or not remains to be seen, but certainly that’s the concept that’s behind it.  I suppose we’ll all find out over the next year or so whether that’s been successful.

I guess there’s one last point I would like to make, just because I’m about to run out of my twenty minutes.  That is just about the relative position issue as between the U.S. and the UK, the New York versus London issue.  It implies really that this is a zero-sum game.  I’m not very comfortable, and I think many people in the industry are not very comfortable, with the notion that it’s a zero-sum game.  London and New York, the U.S. financial markets and the non-U.S. financial markets, are very closely linked and very mutually supportive.  They benefit from each other. 

Maybe no one noticed, and in market cap terms it is still true that the U.S. is far and away the world’s leading financial center, but the U.S. has never been the world’s leading financial center outside of things U.S.  That seems to have been conveniently forgotten in these discussions about what’s happening in New York versus London.  The fact that London is a bigger foreign exchange center, a bigger whatever – doesn’t really matter – the real point is just to bear in mind that what we’re seeing today is a discussion and analysis of a phenomenon which has been very much the case for a long period of time. 

It’s not really new, we’re just tending to look at it differently.  Perhaps what we’re seeing is a U.S. version of what has been the case in the UK for a long period of time, and that is an understanding of the importance of the competitive position of markets and a recognition on the part of U.S. politicians – not necessarily industry participants – that they may not feel so comfortable in that loss of market share, even if practitioners are perfectly comfortable.

Peter Wallison:  Thank you very much, Ron.  Just one question, because I’m so fascinated by this whole idea of principles-based regulation and how it would be done.  You have a principle or a goal or an objective, whatever it’s called, which is “treat consumers fairly.”  That sounds like a principle. 

As you’ve described, you go in and you ask them to prepare a set of their own regulations, how they are going to treat consumers fairly.  What if they don’t follow those regulations?  How do you know that and what kind of sanctions come from that?  You’ve said to them, this is what the rules should be, we like the rules you’ve written.  But then they interpret their rules in a way that allows them to do things that wouldn’t be regarded as fair.

Ronald Gould:  There’s a feeling, and I didn’t talk about it and probably should have, that our engagement with firms is entirely informal.  That’s not true.  The engagement we have with large firms is different than the engagement we have with smaller firms – that certainly is true.  Because the FSA sees itself as a risk-based regulator that accepts something other than zero default possibilities, we have a risk appetite.  Our risk appetite says that we want to focus on certain kinds of firms more than others.  We want to use resources differently as a reflection of that.  It means that we tend to focus resources on larger, more complex firms. 

With those firms we have what we call a close and continuous relationship.  That close and continuous relationship is one which involves a team of people who are dedicated to the supervision of that firm.  That team of people calls in specialists from elsewhere in the organization to look at particular parts of the firm.  So the people who regulate Barclays, when they’re looking at the CDO book of Barclays capital, would be calling on the risk review team within the FSA who are specialists in that area to look at that particular part of the firm. 

In much the same way, with respect to treating customers fairly, we would be asking management to show us what they’ve done and discuss with them whether it meets our objectives.  Remember, all of what we do is being tested against our statutory obligations and objectives.  So how does it affect that?  Can we fulfill our obligations?  Are we confident of that?  That’s the test we apply.

If we feel that in that example or any other example a firm has not come up with what’s required, we will say – back to the drawing board.  You need to do something that is more robust and we will probably point them into particular areas which we see as weaknesses in this area.  We will ask them how they intend to embed these processes in the way they do their business.  Usually we find that the trickiest part is how firms embed these things in their daily business routine, because that’s where slip-ups occur.

We will periodically review – in U.S. terms, examine – firms, large firms more frequently than smaller firms.  As part of those reviews, we will look at, at a level of detail, how well those processes which we’ve agreed to in the first place, assuming that’s the case, are actually working.  We will tell the firm if they’re not and require that they fix it.

Peter Wallison:  Okay.  Maybe we’ll get to more of this later, that’s good.

Let me talk a little bit about Melanie Fein because Melanie is doing a study of the FSA, so this will be a learning experience for her as well as for us.  She’s recently resumed her own financial institution’s law practice after three years at Goodwin Procter here in Washington, where she was a partner in the firm’s business law department.  From 1979 to 1986, Melanie was an attorney and senior counsel at the Board of Governors of the Federal Reserve.  She’s taught courses in banking at Yale.  She’s been an adjunct professor at Boston University and the Columbus School of Law at Catholic University here.  She’s also the author of numerous articles; I won’t even go into all of them.  But one of the reasons she’s been on this panel before is that her interests and her learning is so widespread. 

Melanie Fein:  Thank you, Peter.  I want to first of all compliment Howell on his paper and his presentation, which I think is very informative in helping us to understand how the FSA operates and also in elucidating some of the reasons for the differences between our regulatory system for financial institutions and that of the UK.  Ron, thank you for your very helpful comments as well.

I am particularly fascinated by what I discussed with Ron earlier as the attitudinal differences between the mindset we have in the U.S. for regulating financial institutions and that in the UK, particularly the cross-industry perspective that the UK has on its financial institutions.  Here, someone at the Fed would not dare to think that they could regulate a securities firm, let alone an insurance company.  People in the legal division would not dare to interpret the margin rules, for example, at least when I was there.  We have a very siloed approach to regulatory expertise here whereas in the UK the FSA appears to be capable of multitasking.  They’re multidisciplinary. 

As Howell pointed out, there’s a wholesale institution division and a retail division.  Each division encompasses banks, securities firms and insurance companies. The staff is capable of interacting with all three industry sectors and whatever fringe sectors there might be as well, which I don’t think our regulators are capable of doing.  Of course, that’s not their mission.  That’s not their statutory assignment.

But it is a very useful way of looking at the industry as a consolidated financial services industry, sort of harmonizing what has happened in the industry with the regulatory response.  I don’t know how we would ever be able to duplicate that here, given the unique characteristics of our system which will probably keep our industries separate for many years to come.

Also the principle-based system requires a totally different mindset from the one that we have here.  I don’t know how many pages of regulations we have here compared to the 8,500 in the UK but I’m sure it’s many times more than that.  Just to give you an idea of how dramatic and how committed the FSA is to the principle-based regulatory philosophy, if one can call it that, versus our rules-based system – the FSA recently got rid of all their money laundering regulations and have just a two-page regulation.  It’s hard to imagine us embracing that kind of wholesale repeal or revocation of regulations and leaving it to the industry to self-regulate.

As a lawyer who sometimes advises banks on compliance issues, I find that it would be somewhat difficult for us to incorporate a principle-based system, at least to the same extent, here because of the litigious nature of our society that is actually built into many of our laws.  Howell and I were talking earlier, and he told me that there’s no 10b-5 private right of action in the UK, and there’s a lack of private right of action under other UK laws as well. 

Here, our litigation solution is embedded in the laws, where people do have a right to sue institutions and bring class-action lawsuits.  Howell or Ron told me earlier that there are no class actions in the UK, which is remarkable.  So as a lawyer advising on compliance, it’s very helpful to have rules that you can rely on to prescribe conduct within an organization, that is going to protect the institution in the event of litigation.

I also find it very difficult to grasp the notion of principle-based regulation that relies on a telephone call to the regulator and maybe you do a memo to the file, and then you develop a course of conduct based on that guidance from the regulator.  But how can you be sure that your competitor is getting the same advice?  How can you be sure that the person you talk to on the phone is going to be there next week and that you’re not going to be questioned by the person who takes over their job two months from now?  I think there’s a lot of trust between the regulator and the regulated institutions that occurs in the UK that makes that possible somehow, I’m not sure how, but we just simply do not have and would require a lot of change in our mindset in order to accomplish that. 

But I think that the UK system has a lot to commend itself.  Just the numbers that Howell put on the screen in terms of the cost of regulation here suggest that perhaps we should be trying to learn some lessons from the FSA approach to regulation.

With that, I will turn it back to Peter.

Peter Wallison:  Thank you very much.  Our next commentator is Heidi Schooner.  Heidi joined the faculty at the Columbus School of Law at Catholic University in 1993.  She has also been on the visiting law faculty at Suffolk University and George Washington University and at some point was in the general counsel’s office at the Securities and Exchange Commission.  She’s published a number of articles exploring the regulation of financial institutions.  Her scholarship addresses issues ranging from specific examination of the enforcement powers of bank regulators to broad scrutiny of efforts to modernize bank regulatory regimes.  Heidi, we’re delighted to have you here.

Heidi Schooner:  Thank you.  I want to thank Howell, as everyone else has, for his wonderful paper because it really gives us a lot of wonderful things to think about and is a great template for comparing the two systems, the U.S. and the United Kingdom system, for structuring regulation.

I know you all will be very relieved when I tell you that I have the answer.  I know why these systems are so different.  I’m only saying this halfway with my tongue planted in my cheek, but I want you to think about – and especially I think it’s potentially true with respect to enforcement intensity. 

I want us to think about the orientation of the executive management of the FSA versus the regulators in the United States.  Maybe Ron will correct me but I did a head count of the sixteen board members of the FSA and they are all accountants, economists and other business professionals.  The five commissioners of the SEC are all lawyers.  The board of the FDIC, four of the five are lawyers.  The Comptroller is a lawyer and the first senior – whatever Julie Williams’ title is, she’s obviously a lawyer.  The Board of the Fed obviously is different, but I would contend that that’s because it’s the central bank.  They are all economists.

But I really think that that orientation is a piece of this.  I didn’t do any empirical work like Howell does and I wish he would, because he could do this better than I could.  I don’t know how that impacts the staff.  I think the one statistic Howell gave us about the difference in size of the enforcement divisions of the FSA versus the SEC, that’s probably mostly lawyers there.  From my days at the SEC, it felt like everybody was a lawyer at the SEC.  There were a couple accountants running around but everybody else was a lawyer.  I think lawyers do pervade our agencies in a much more significant way than is likely true at the FSA.  That’s just a guess; I’ve not done any empirical search with respect to that, but I think that is a potentially important observation to lay onto what Howell has already pointed out.

I would also say, with respect to regulatory intensity, enforcement intensity, I think it’s true that many of the enforcement powers that the FSA is currently using are relatively new.  These are statutory powers, some of which didn’t exist before 2000.  So my other sort of cynical comment would be – just give them time.  You get a lot of good press by being a good cop.  You get a lot of space on the front page of the business section from bringing splashy enforcement actions.  So part of me feels like to the extent the enforcement division at the FSA is successful, it’s going to continue to grow.  So we may not see these differences over time.  So I think as they are successful and as their experience with their statutory regime matures, they get more experience and more precedent, you may see an expansion of that.  I’m not hoping for that necessarily but I think it’s quite possibly true.

With respect to the goals aspect of Howell’s paper and looking at the different goals, I have a couple different thoughts.  The first really gets us to this distinction between principles versus rules or standards versus rules.  I have to throw out a potentially much more cynical view of that distinction.

The first comes from what is probably the obvious observation, that all systems are a hybrid of principles and rules.  There’s no system that’s all one or all the other.  So if you go to my particular interest, bank regulation in the United States, we rely quite heavily on a principle for enforcement in the bank regulatory area.  The governing principle is unsafe and unsound banking practices.  There are some regulations that define what an unsafe and unsound banking practice is but not a whole lot.  Those regulations don’t tend to be the things that the bank regulators are focused on when they bring those enforcement actions.  So that’s a very principle-based approach to enforcement and a very important regulatory tool.  The FSA’s handbook is a great example of rules in that system.  So first of all, my observation is I don’t think it’s necessarily as big a difference as sometimes it’s thought of.

The other observation about principles versus rules is I also have a suspicion that it’s cyclical.  Just like regulation and deregulation over time are cyclical, you can have regulatory systems that run the cycle.  They go through a period where they very much rely on principles because everybody likes that sort of deregulatory feel or the light-touch regulation.  Then you have the Melanie Feins who have the clients out there saying, you know, we’d really like to just have some rules so we know what we should do.  Then you move more towards more rules, more specific guidance from the regulators.  Then the rulebook gets really big and what we have not been able to do in the United States is get rid of the rulebook.  But a cycle going the other way would be to get rid of the rulebook.  So I wonder if the FSA is just in a different point in their cycle than we are and maybe that will change over time.

I do think, looking at this snapshot of time, looking at the principles versus rules approach, and certainly the United States is always – in many areas, not just in financial services – always held up as the poster child for the rules-based approach.  I do think it can make the systems look more different than they really are.  So Howell, I think very appropriately, points out that in the statutory regime that governs the FSA, you have very clearly stated regulatory goals.  So we have those goals that we can assess.

In the United States, I think you’d be hard pressed to find statutes that say what it is that the FDIC is supposed to be doing from a global standpoint.  Same thing with the OTS and OCC.  The Fed, you actually can find a statement of their goals, but it’s for monetary policy, it’s not for supervision.  So I think in the United States you have to look more at the details to figure out what the big picture is.  I would argue that while I do believe that Howell is right that particularly with respect to securities regulation that we are much more consumer protection-oriented, I would also have to emphasize what Peter said at the very beginning. 

I really believe that even though our system isn’t overtly focused on systemic risk as the number-one goal, I think in effect it is.  I would go as far as to say that the entire FDIC insurance program is really about systemic risk.  It has a wonderful ancillary consumer protection effect but it’s really focused on a systemic risk concern.  I think if you go back to 1934-35, when it was put into place, I think that what Congress was reacting to was the prevention of bank failures and contagious bank runs.

So I think that the principles versus rules dichotomy can sometimes overstate differences in the goals of the regulatory system, simply because they’re stated differently, when maybe they’re not so different underneath.

I’ll close with – I just want to talk about it because I loved Howell’s observation about the political economy aspect of looking at these two systems.  This idea that in the UK there was this willingness to sort of muddle through and set up a new statutory regime that didn’t have all the I’s dotted and T’s crossed.  I would go back to the lawyers.  In a system like ours, where everything is dominated by lawyers, they’re not set up to adopt a system like that.  Lawyers are trained to dot the I’s and cross the T’s.  So I just don’t ever see us embracing a system that would allow us to go for a reform through that sort of muddling through approach and sort of relying on good faith that it’s all going to come out okay in the end.  I think that again comes back to the orientation of the executive management of the agencies.

Peter Wallison:  Very interesting, thank you very much.  Tom Stanton is our final discussant, commentator. Tom is a veteran of our panels on various subjects, because he is very broad-gauged in his interests in organization.  He’s a fellow now at the Center for the Study of the American Government at Johns Hopkins University.  He is also a member of the board of directors of the National Academy of Public Administration and a past chair of their standing panel on executive organization and management.  He provides legal and policy counsel relating to the design and operation of federal programs to federal, state, local and international organizations, and to many federal agencies.  I won’t go into all the publications he’s responsible for but you can find that all in your material.

Thomas Stanton:  Thanks, Peter. I can hardly wait to hear what I have to say.  This has been a wonderful paper and Ron, your contributions, and also both of you, Heidi and Melanie.  It’s been really interesting.  I’d like to touch on points in the order that you did, sort of the political context, the goals, the regulatory intensity, and then finally make a proposal that may or may not find grace in your eyes.  I also have a lot of questions that maybe we can discuss later.

With respect to politics of financial regulation, I’ve got to go from lawyers to lawmakers.  Here we have no better authority than the Honorable Alan Greenspan, who has told us “Congress serves as a strategic planner of the U.S. financial system and in this capacity shapes the overall structure of our financial regulatory system and balances the costs and benefits to that system.”  Reading this paper, hearing this presentation, I get the suggestion that perhaps you think the British parliament is a better strategic planner.

What you do is you contrast the creation of FSA on the one hand in the late 1990s and with Gramm-Leach-Bliley.  I guess I’d like to suggest it’s also useful to consider changes that we made in FIRREA and FDICIA, in the aftermath of the savings and loan debacle and the problems in New England banks.  What we did there was to add significant improvements to supervision of insured depository institutions, including the effective preemption of lax state supervision of state-chartered institutions in places such as the Southwest and Texas that had helped to create preconditions for significant taxpayer losses. 

In other words, our political deference to fragmented supervision and the role of state financial regulators gave way before the realization that we need to set a floor on the ability of depository institutions to precipitate serious harm in the financial system.  I’d like to come back to this idea at the end of these remarks.

The differences in political cultures between the U.S. and other countries mean that any reform proposals need to be shaped to make progress in the context of our peculiar system.  It is clear, as you’ve pointed out, that Parliament can move much faster than the world’s greatest deliberative body.

Moreover, the very structure of FSA has echoes in the American political history.  The FSA is organized as a private corporation with a sixteen-member board of directors.  Eleven members of the board are independent and five are insiders of the FSA itself.  Does this ring any bells?

While the structural parallels are not complete, particularly with respect to shareholders, we did have two banks of the United States, private companies that were charged with regulating monetary policy in the financial system as it was in the 19th century.  The destruction of the Second Bank of the United States and the political triumph of smaller state banks that had chafed under the hegemony of the Bank of the United States have made a lasting mark on the history and fragmentation of U.S. financial regulation. 

Before we leave politics, I’d like to raise a question for later.  To what extent does Parliament micromanage the financial system in a way comparable to the United States Congress?  Consider for instance laws that Congress enacts to protect certain financial sectors against encroachment by competitors operating under different charters.  Here, from my experience in the mortgage industry, let me talk about two examples where Congress has basically protected the insurance industry at the potential cost of efficiency of the U.S. financial system.  There are two examples that stand out in the residential mortgage market.

The first is private mortgage insurance, which applied as it is today to each individual mortgage is arguably a complete anachronism.  It potentially would be much more efficient to insure mortgage pools rather than individual mortgages and thereby significantly reduce mortgage insurance costs.  Absent laws to the contrary, mortgage pool insurance could come from a variety of sources or even from large lenders with the financial capacity to self-insure.  However, the Congress enacted laws in the charter acts of Fannie Mae and Freddie Mac that require conforming mortgages with loan to value ratios above 80 percent to obtain individual mortgage insurance.

An analogous case could be made with respect to title insurance, which is protected from being rolled into mortgage costs by the controlled business provisions of the Real Estate Settlement Procedures Act.  Again the question: do politics in Britain extend to that kind of protection of the franchise value of favored charters at the cost of innovation and more open competition?  I’m sure you can all give examples from other parts of our financial services industry.

So let’s consider goals.  Here again I have a question and a comment.  The question: Howell, you mentioned that “too big to fail” remains a malign but extant policy of U.S. bank regulators.  The question is, how does FSA deal with “too big to fail”?  Since that policy has not yet been tested in Britain, how credible is it?

Now the comment.  The paper makes much of consumer protection as a major goal of U.S. financial regulation.  I believe that measures have to be analyzed before they are deemed to provide “consumer protection.”  Consumer protection through required disclosures such as Reg Z or the establishment of rules to allocate losses such as Reg E can be cost-effective.  On the other hand, some so-called consumer protection, as in the title insurance example, can easily shade off to protection for producers rather than consumers.  It’s important in cross-country comparisons to determine the extent that protection of the franchise value of particular types of institutions against competition is a regulatory goal, whether explicitly stated or not.

Regulatory intensity.  The statistics on regulatory intensity are interesting.  Clearly the United States has many more staff occupied with financial regulation than does the FSA – 43,000 in the U.S. versus 2,700 for the FSA.  But this issue also might benefit from increased scrutiny and you’ve actually begun that process, Melanie and Ron, and you, Howell, in terms of trying to look at the quality of financial supervision between the two countries.  Or in the end, as has been suggested, do differences in legal culture swamp any effort at making such qualitative judgments?

In that regard I’d like to suggest another set of numbers.  In the UK, some 1 million people work for financial services companies regulated by the FSA.  In the U.S. the comparable figure, and this is a 2001 number – it’s probably gone up slightly since then, who knows – is 5.8 million employees.  In this context, it would seem to be relatively unimportant whether 42,000 staff were concerned with financial supervision or some lesser number.  The personnel ratio of regulators to regulated is so small as to make those differences unimportant.

Again the essential question is the one of quality of regulation.  For example, whether too many of the regulatory staffs perform unimportant or redundant or inefficient functions that have little value to the strength and performance to the financial system.

Again, this leads to a question both for Howell and Ron: how does the FSA – and you were starting to answer it, Ron – cope with information asymmetries between the regulator and the regulated firms that make examination such an important but sometimes – Barings; choose your example – unsuccessful function.

Now the proposal.  The most important benefit of this paper is the way that the integrated approach of the FSA points out shortcomings in our own supervisory system.  In particular, we lack a single agency that is responsible for analyzing and monitoring risks that cut across the financial system as a whole.  We do have both the Fed and the Treasury but neither have this kind of complete cross-cutting responsibility.

However, in today’s fluid financial sector, risks travel easily across institutions and types of institution.  It was in the aftermath of the savings and loan debacle that I first perceived what I cheerfully call Stanton’s law: risk will migrate to the place where the government is least equipped to deal with it.  In the savings and loan cleanup, Congress greatly strengthened supervision of thrift institutions and imposed bank-type capital standards and strict supervision.  In the process, we facilitated the shift of hundreds of billions of dollars of mortgages and the attendant risks to Fannie Mae and Freddie Mac, where capital standards were low and supervision was much weaker. 

This country urgently needs a single organization with the capacity to monitor and analyze risk from the perspective of the financial sector as a whole, including insured depository institutions, the many major non-bank financial institutions such as GSEs, large finance companies, insurance companies, and investment banking firms.  But as this paper shows so well, the political culture of the United States will not favor a large consolidated regulator.

That leads us to an idea that may meet the need for integrated risk monitoring and analysis without offending our longstanding if slightly dysfunctional cultural norms.  The idea is simple.  Create an agency with the responsibility for analyzing major risks across the financial system but lacks the authority to do anything about those risks.  Wherever that agency is located or if it’s independent, it can and should be designed to have some powerful friends to help protect its ability to report accurately on major financial risks.

The issue that I’m constantly bedeviled by in regulation is information asymmetries.  By creating this kind of organization that clearly has no authority to do anything about what it finds, you create the ability for information to flow that might not flow as easily within the legalistic financial regulator context.

There’s a model for such an organization from the transportation sector – slightly different but it’s a model – the National Transportation Safety Board.  The NTSB is required to assess risks in the transportation sector – airplanes, Metro, railroads, you name it – and to examine and report on major transportation accidents.  The NTSB carries out its mission in the context of powerful industry groups and firms and powerful agencies such as the Federal Aviation Administration.  The FAA frequently ignores NTSB recommendations.  But those recommendations are a matter of public record and are available to policymakers when the need arises.

This is not the same thing as having an FSA with the authority to analyze major risks and the power to address them.  On the other hand, it falls within the piecemeal approach seen within FIRREA and FDICIA of making incremental reforms that help to address major concerns with respect to the financial system, albeit – as in the case of those two laws – far too late.

Thank you very much for a most interesting piece of work.

Peter Wallison:  Thank you, Tom.  First let’s see if we can get some reaction from Howell and Ron about what Tom and the others who have commented here had to say.  Then I want to go into a little bit on this principles and rules business.

Howell Jackson:  There’s a lot to comment on.  I have to say, I particularly like the analogy of the FSA to the First and Second Bank of the United States.  I’m pretty sure, were he here, Andrew Jackson would veto the FSA.

Tom said a lot of other things that are interesting.  Let me respond to a couple of them.

The point about the numbers, I think you’re quite right to say $5 billion is a big number and 44,000 seems like a lot of people, but compared to the financial services sector these are small numbers.  Stock market capitalization, bank assets--if you normalize them on the basis points, they’re relatively small numbers. 

However, I think it’s important to note that I’m just looking at one piece of regulatory costs here.  They probably amplify.  So for every regulator in Washington, there are a certain number of regulators in other places.  There are lots of indirect costs of regulation.  As a first approximation, one might think that in looking at [indiscernible] stuff is in some sense an amplification.  So overall, regulatory costs amplified probably follows the ratio.  That might not be the case but at least plausibly.

On the proposal, which I think is an interesting proposal, I give it a good chance of passing because it adds an agency.  If history is any guide, that’s a plus.  I actually think it would be a good thing to do.  There are interagency task forces that exist to do this periodically, but a standing group with expertise to collect information, to do critiques, I think would be a valuable thing to do.  We actually have a lot of knowledge about the banking industry in part because the Federal Reserve subsidizes banking regulation studies.  So we know in some sense too much about what the Fed banks do and the rest of the financial services sector – the GSEs, the securities market and hedge funds – all these things would profit from this kind of study.

The one thing that I would say is I would include in this meta-agency’s mandate analysis of the consumer protection cost-benefit analysis.  I am totally sympathetic to you that much of what comes under the guise of consumer protection – including RESPA and many other things – is not really consumer protection, it’s doing other things.  When I say consumer protection, I’m using it for good and for ill.  So a lot of what we do is one sort of consumer protection.  We just aren’t very good. 

It’s interesting, OMB is in charge of cost-benefit analysis in the United States but it is a light touch with respect to the financial regulatory bodies because they’re independent agencies and sort of outside of the purview.  So our development of cost-benefit analysis in the financial services sector is not good. So when the SEC studies board governance, it’s pathetic in its analysis.  I’m not sure they’re wrong but they just didn’t approach the issue in a good way.  So when you get this group going, I’ll add a box to one of my slides, but put in consumer protection.

Ronald Gould:  I’m not sure where to start.  Tom and everyone else have come up with so many points.

Let me first of all wholeheartedly endorse the implication from Heidi that there should be fewer lawyers.  I think the whole issue of how embedded litigiousness is in one place versus the other is clearly part of this problem.  The challenge is that reversing that tendency seems to be beyond the wit of anyone.  Frankly, I don’t hold out very high hopes for it.

Tom made a point about the differences that exist between the nature of the British Parliament’s involvement in these things in contrast to the U.S. Congress.  I think it’s fair to say that parliamentary involvement, because its agenda is driven and shaped by the government whips in a way which is just simply not true in the U.S., is very low unless the government of the day wishes it to be otherwise. 

So coming back to the observation that Peter made early on, the fact that the FSA was conceived and implemented in such a short period of time could only have been true, could only have been possible, if the government of the day wished it to be the case and could put it as a centerpiece of its core legislative agenda, and then said it will happen – three-line whip.  That is what happened.

That is not possible in the context of the U.S. Congress.  The result of that is that while you can make something happen very quickly if the government wishes it to happen, conversely the notion of lots of relatively small, highly targeted protections – for example, for different sectors or different franchises within the economy – are much more difficult to achieve.  So that level of involvement is – it would probably be overstating the case to say it’s absent, but that level of involvement is infinitely lower in the British system than would be the case in the U.S.

I think Tom or Heidi raised a question about the “too big to fail” doctrine.  I think the first thing that needs to be pointed out is that because that responsibility really rests with the Bank of England, I’m going to make an assertion on their behalf which may or may not be accurate, but I believe it is.  Yes, it is a doctrine that still very much exists and it has been tested.  Many people in the U.S. would either not know or wouldn’t have recognized the fact that in the 1990s the National Westminster Bank, which was the second largest bank in the UK at the time, was bailed out by the Bank of England, and only just.  There were several other banks that came equally close and were also bailed out.  So it is a mechanism that exists and has been used in the past in the UK.  So in that sense, very similar to here but nothing to do with the FSA.

I think we should remember when we look at regulatory costs – and this would be true, to be honest, in both the UK and the U.S. – we’re looking at the numbers we can look at, which is that which relates to the regulators.  What we can’t look at is the costs to the industries that are regulated.  Those, I would suggest, are many times the numbers that Howell had on his slides earlier. 

I suppose the only good thing I would assert, though I couldn’t prove it, is that the regulatory approach in the UK would probably produce a lower industry number than would be the case in the U.S.  That would be an added attraction to the system assuming you are otherwise comfortable with the quality of regulation that you’re achieving.  I think there’s some evidence to suggest that there is a reasonable comfort level with the quality of regulation being achieved right now in the UK.

I should also add one other thing that I didn’t mention earlier on, and that is that the UK actually regulates some things that are not regulated in the U.S.  I have to laugh sometimes because it’s in an area where you would think if it was a very light-touch form of regulation we wouldn’t be doing it at all. 

One of the fastest growing areas of the financial services sector in both the U.S. and the UK over the last few years has been the hedge fund sector and the private equity sector.  Both of those are regulated in the UK and have been for many years, there’s nothing new about it.  Neither of them are regulated, generally speaking, in the U.S.  It seems to be the source of great concern both within the regulatory community and among the industry in the U.S. 

I think it’s very interesting that if you talk, as I do, to practitioners in the UK in those two particular areas, you find widespread – maybe not universal but very nearly so – support for the value that they have received as a result of being regulated, because the regulation has been proportionate and sensible, not seen to be unreasonable, and it has also been intelligent in the sense that they feel the people they’re talking to understand the business that they’re in.  That makes a huge amount of difference in information flows, which takes me to the last point with regard to information asymmetry.

I do think that because it does require a certain level of trust which may not exist between the industry and regulators in the U.S. and which I think certainly to a much greater extent does exist in the UK between the regulator and those regulated, there is a higher level of trust and that trust is built on this notion of engagement that I talked about at the very beginning.  If you have a fairly constant and high level of engagement with people who you feel understand the business you’re in and can deal with it in a relatively common-sense way, then the likelihood of information flows being less asymmetrical increases dramatically.  I think that certainly helps to improve the quality of regulation in the UK and reduces some of the concerns that might otherwise arise from a somewhat less examination-oriented approach to regulation, as would be the case in the U.S.

My final comment on your proposal is that like Howell, I think it’s a great idea.  The only real shortfall it has seems to be that by definition it’s only going to be operating after the fact.  Like an airplane or train crash, that doesn’t do the people who were involved much good.  It is a bit of a shortfall that might have some political repercussions that might be pretty uncomfortable.

Peter Wallison:  Thank you very much.  Before we go to questions, I have just a couple of points I’d like to make in response to some of the things that have been said here.

First of all, there probably wouldn’t be in the United States as much resistance to hedge fund or private equity fund regulation if the regulation in the United States were of a different character, somewhat more like it is in the UK.  I think these groups look at what the SEC does and they say – not for me.  That’s quite an important factor.  Just to mention a number, the securities industry in the United States estimates that regulation costs them $25 billion a year.  So if you want to take that number and compare it to the cost of the actual regulators, you can see some kind of relationship there.  Of course it’s the industry’s number, but it’s a number.

On the business of principles versus rules – I don’t want to exactly defend the lawyers, even though I am one, but I want to say there’s a lot of talk about this stuff and it doesn’t make a hell of a lot of sense to me.  I don’t think we recognize that principles versus rules is really a power relationship question: who has the power?  Again, I’m not referring to the UK because you’ve got a completely different cultural attitude here about regulation.  But in the United States, who is the one who is making the rules is the one with the power in this sense, or using the rules is the one with the power.

Let me put it this way.  If we had a tax system, for example, which was principles-based so that the tax assessor could go into anyone’s business and say here’s the principle – we want all your money – and you haven’t paid us enough.  That would be a case of the power resting with the tax people.  On the other hand, if you have an Internal Revenue Code and all of these regulations, the defense of the taxpayer is – I followed the rules.  If I follow the rules, you can’t do anything to me.  That’s exactly the same thing as is true in the financial area.  If the rules are made and everyone can read and understand and interpret the rules at least reasonably, then the power rests with the people who are the regulated rather than the regulator.

On the other hand, if the rules are simply principles then the regulated industry has to wait to be told by the regulator how they should behave.  That puts the power in the hands of the regulators.  The same thing would be true in the