Competition and innovation in financial services: the regulator’s perspective

Speaker: Christopher Woolard, Executive Director of Strategy and Competition
Location: Cheung Kong Graduate School of Business, Shenzhen, China
Delivered on: 11 May 2017

Highlights:

• Competition is central to the effective running of financial markets. It drives innovations that consumers want and ensures value for money.  
• The FCA intervenes where competition can’t perform its vital function and there’s a risk of consumer harm.
• The FCA’s Project Innovate positively fosters innovation that focuses on offering better outcomes for consumers.

Note: this is the speech as drafted and may differ from delivered version.

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It’s a great privilege to be able to give this speech today and to be in China. Technology leaders here are transforming the financial services sector as we know it and revolutionising the way consumers access products and services as a result.

In many respects the way the market has developed is very different from Europe or the US. But parallels can be drawn and I’m keen to gain all the insight I can while I’m here.

The past few days I’ve been in Beijing, Shanghai and today Shenzhen and I’ve seen first-hand the developments that are emerging.

A world where so much is changing in financial services may pose challenges to traditional business models, but also offers significant benefits to consumers – how do regulators respond to that?

Today I'm going to talk about the UK regulators’ approach to competition.

And in particular:

• how we think about competition and regulation
• how we approach our competition duties and powers
• how we promote innovation

In 2013, I gave a speech in London called Competition and conduct regulation in financial services[2].

It was a short speech, covering some simple points about competition and innovation. Why we as a financial regulator cared about it. How most financial regulation, quite rightly, focuses on stopping bad things happening, but often does so at the expense of worrying about whether good things are being stifled.

A few people said to me they had never heard a financial regulator talk like that before. I think some people in the room thought it was fine words. But just words. And I suspect a lot of people were maybe a little confused by it.

A lot has changed since then. But before I talk about the journey we’ve been on, I want to take us back to the question of why we are so interested in the field of competition and innovation? What do we want to get from it?

How we think about competition and regulation

Regulation is a powerful tool in shaping markets

Let’s start with the basics.

The FCA is given a mandate by parliament to ensure markets work well. We have duties to ensure market integrity, protect consumers and promote competition in the interests of consumers.

There are several ingredients needed for this: integrity underpinning the financial system, clarity around standards and expectations and transparency in behaviour and decision-making, to name just a few. It is our duty to intervene when we perceive obstacles to this optimal state of affairs.

Regulation is a powerful tool in shaping markets and we know our vigilance and interventions in financial markets give consumers confidence.

This is integral to the success of the overall system, so we must step in to prevent harm and put things right when they go wrong.

But effective markets also rely on competition, in essence, the ability of consumers to exercise choice and the disciplining effect on firms when consumers walk away from them.

There are a number of different ways in which we can promote competition and, in order to have maximum impact, we aim to make use of all of them.

Our ultimate aim is that the markets we regulate are clean, fair and competitive. We apply our powers to ensure consumers are empowered to make good choices and innovation is free to play its part in driving value.

Yet, this is a complex area to think about. For example when it comes to innovation, some would argue that amending regulation to improve competition can weaken financial stability.

Policy makers could, for example, lower capital resource ratios to lower barriers to entry. But this could have consequences for financial stability if a systemically important bank doesn’t have sufficient capital and goes into a disorderly wind-down. In light of recent history, I think we’re all aware of the impact that could have.

The counter argument is that lowering barriers to entry creates more entrants, creating a more diverse market. This can lower the likelihood of banks becoming systemically important, which can have positive implications for financial stability. Furthermore, firms subject to competitive pressures tend to be more efficient, so competition can create a healthier market in the long-term.

The empirical evidence in financial services is inconclusive.

Nonetheless, examples from other markets show us that there are ways to lower barriers to entry without directly increasing risks; for example, as has been achieved in the UK pharmaceuticals market. And yet, despite the compelling evidence from many sectors, many financial services firms are confused when we talk about the need for more competition in the market. In particular we often hear the argument that the existence of multiple firms means there will be competition.  

But it’s not just a question of numbers. We also need to consider the propositions on offer to consumers. Is there a diversity of choice – both in the providers and the products and services available to consumers?

Our duty is carefully framed - competition in the interests of consumers. It distinguishes a healthy, competitive market from a race to the bottom, the insatiable drive to expand or sell at all costs.

We want a race to improve products and services. We want firms to compete to win more customers, and to do this by improving service, quality and price.

The regulator can't force firms to compete, but we can help create the conditions where they will.

When we set about this task we start at home.

Our first consideration is how our own regulation shapes the market.

We know that regulation, although an essential bulwark against misconduct, anticompetitive practices and consumer detriment, can create unnecessary barriers to entry.

This was something we saw back in 2013 when we conducted a review of requirements for firms entering or expanding into the banking sector.

We found that some prospective entrants to the market saw capital and liquidity requirements as disproportionately high, while there was also uncertainty around the authorisation process and the way in which it was executed.

In response, we made some pretty significant changes.

For authorisations we introduced a new ‘mobilisation’ option, in which authorisation is granted to firms who meet our essential requirements but with a restriction on activities where further work is to be done.

Building on that work, we, along with our sister regulator the Prudential Regulation Authority, launched the New Bank Start-up Unit early last year. The Unit acts as a one-stop shop for prospective entrants, offering support to both newly authorised banks and those thinking of becoming a new bank. And we looked closely at capital requirements, lowering them from a minimum of £5m to £1m.

These efforts are really bearing fruit.

In the 5 years to 2010 there was only 1 new UK retail bank authorisation. But in the following 5 years there were 5. And since 2015 we’ve authorised a further 9 UK retail banks.

The measures we took here are a clear example of the balancing act we must perform as the regulator: between maintaining high standards – ensuring new entrants to the market are adequately prepared and won’t pose a risk to consumers – while ensuring that those standards do not stifle innovation or deny access to new participants.

We’re committed to squaring that circle. It guides our work every day.

I also want to just say a few words about the important role regulation can play in building markets by maintaining trust and confidence in the system.

As former Bank of England governor Mervyn King has said: ‘trust is the ingredient that makes a market economy work.’ And the presence of a strong regulator plays a highly significant role in bolstering that trust.

This isn’t a new concept, but one that sometimes seems to be forgotten in debates about regulation.

If we look at the earliest surviving Anglo-Saxon law codes in England from around 750 AD as well as dealing with crimes like manslaughter and theft, detailing when military service had to be given they also set out clearly how markets are to be held and how customers should get fair measures. Six hundred years before that here in China, the Han dynasty was doing almost exactly the same thing.

The right balance of regulation can be a powerful way of promoting competition in the interests of consumers and wider economic growth in the real economy.

How we approach our competition duties and powers

As well as ensuring the regulation we design is in order, we also have the ability to intervene in the market using a range of competition powers.

The FCA is almost unique amongst financial regulators in having competition powers, these powers are still relatively new and it’s the area firms tell us they understand least about what we do.

We have begun the process of setting out how we see our powers working together in a short document we published a few weeks ago called Our Mission. One of the key concepts in the Mission is the idea of harm. That we should look beyond simple compliance with rules, important as that is and the risks of those rules being broken, and ask fundamental questions about whether markets are working well for consumers.

Later this year as part of our work on our Mission  we will publish our ‘Approach to Competition’, setting out in detail how our philosophy around competition influences our work.

But I hope that even in advance of this our actions speak for themselves.

Take for example the market study[3] we conducted recently into the asset management industry.

This was a significant undertaking for us, not least because the asset management industry is so big, and so important to the long-term wealth of millions: the UK’s asset management industry is the second largest in the world, managing almost £7 trillion of assets.

I should stress there was no suggestion of rule-breaking in the market. Rather we wanted to step back and consider how the market as a whole was functioning.

What we found was weak price competition in a number of areas of the asset management industry. And that the level of the charges faced by consumers have a fundamental effect on the value of their long term investments and pensions.

So one of the things we are proposing is a package of remedies to make prices, objectives and performance clearer and more comparable for those investor groups that want to find better value in the market.

The asset management market study is a clear example of the FCA using our powers to ensure competition is able to perform its vital role in a crucial section of the market.

A further example is our work in the credit card market. There are 60 million card accounts in the UK. For the vast majority of customers the market works well, but around 3.3 million people are in persistent levels of debt. They are also some of the most profitable customers for credit card firms. We are using our powers to change the balance of incentives for credit card firms to ensure that fewer people get into persistent debt and get help quicker if they do.

Last but not least, we also have powers under the Competition Act to investigate anti-competitive practices and have a number of investigations in train.

How we promote innovation

As well as thinking about how existing markets are operating, we also think about how the process of competition can be encouraged by ensure we promote new entry and innovation in the market.

Which is why the FCA has made positively fostering innovation a priority.

As I hope I’ve made clear, competition is not an end in itself.

Instead, the role of competition is to drive innovations that consumers want and offer value for money.  

But, as everyone in this room knows, what consumers want evolves at a tremendous pace.

Once upon a time the cheque was an innovation.

But even it has had to innovate in order to stay relevant to modern society. Just recently it was announced that cheques will now clear in one day rather than six thanks to imaging technology.

This – the evolution of a product over time – is a defining feature of today’s innovation landscape.

For example, early attempts at robo-advice were simplistic, only able to cope with very straightforward scenarios and relying on limited data. But as more data becomes available, such as through open data initiatives, and analysis of that data improves, models become refined.

The innovations that stick are the ones that give consumers options they’ve never had before and enhance their everyday experiences.

Clayton Christensen of Harvard Business School in seeking to explain why some products are successful and why others aren’t, landed on what he calls the ‘jobs to be done theory’.

It relates to the context in which consumers buy products. When consumers have a need, that’s the ‘job to be done’. The product is then ’hired’ by the consumer to carry out that task. So it’s not the product or service itself that interests a customer, but what that product or service does.

So how do we as regulators try to encourage that kind of innovation?

In the UK we launched Project Innovate in 2014 to help firms tackle regulatory barriers: be it through clarifying regulatory expectations, examining our own rules or enacting policy changes.

Since it launched, our Innovation Hub, a unit dedicated to working with innovative businesses, has provided assistance to 359 firms.

Seeing these innovative businesses flourish, and knowing the role we’ve had in making that happen, is immensely rewarding.

But we shouldn’t pretend it’s without risk.

Before we support an innovative business we have to be convinced not only that its proposition is genuinely innovative, but also that it has consumer benefit and, crucially, that it will not cause consumer detriment.

But we also understand that there is some trial and error for most start-ups – pragmatism plays its role.

And this is crucial, because if we are serious about not having regulation stifle innovation, we need to be cognisant of the different circumstances of the firms who come to us.

We can’t be a regulator that designs policy by considering only existing business models and consulting solely with incumbents, so we take the initiative to understand all perspectives. And Innovate has been hugely important in improving our understanding of innovative firms.

Both we and the firms in Innovate have been learning.

One such firm is Aire, a credit reference agency that is breaking the mould.

Aire’s model focuses on a previously underserved sector of the market – thin file clients, those who are financially capable but unable to get credit because of limited credit histories. Most commonly affected are young adults, the elderly and immigrants, all of whom have had little or no recent interaction with the credit system.

Many of these thin file consumers are responsible spenders and savers, but are unable to prove it. The impact can be severe, with some thin file customers being shut out of the housing market because they can’t access mortgages.

What Aire does is use a wide variety of information sources, including bank account data and social networks like LinkedIn. It has now built one of the largest datasets in UK for use in creditworthiness forecasting for thin-file consumers, and has been invited to share its insights with international regulators. 

And that international angle is very important. We have signed a series of bilateral agreements with other regulators including the People’s Bank of China designed to promote understanding, but also to reduce some of the barriers new innovate firms face when developing their businesses in a global market.

Freedom, not a free-for-all

We’re confident that a regulator’s approach can be both progressive and protective

From payment methods to microfinancing to credit reference checks, innovations across the financial services landscape are making a meaningful difference in consumers’ lives.

We understand that firms have to be given space and support in order to innovate in the interests of consumers. It was this which motivated us to launch Project Innovate.

But giving firms that freedom doesn’t mean we have to sacrifice our objective to protect consumers.

We have no intention whatsoever of presiding over a free-for-all, and a thriving innovation culture does not mean a regulatory Wild West. So it is vital that we prepare firms who want to enter that system.

When it comes to innovative firms, we’ve aimed to streamline this process through our Innovation Hub. Through direct contact with our team, innovators looking to enter the market have access to fast, frank feedback on the regulatory implications of their concepts, plans, and choices.

We have also pioneered the regulatory sandbox – a space where firms can pilot the very most innovative products and services. Today the UK sandbox is the largest of its kind in the world and attracts a range of international businesses. 

The benefit of the sandbox – and the reason the model is now being copied elsewhere – is that it gives industry the freedom to break new ground and encourage creative solutions, even in an environment where there is limited public appetite to accept business failure if things go wrong.

Critically, our sandbox still requires firms to meet our standards of consumer protection.

We also agree a plan up-front with firms in the sandbox what will happen when the trial ends or if we stop it. That means the firm can be clear on its regulatory risks, and we can both be clear how consumers will be protected. In return firms can test their products in the market with real customers for a limited period of time.

Firms in the sandbox will be in very close contact with us throughout the test period and we will also work with them to research the impact of their service. The aim is we all learn from the trial.

I talked earlier about the damage that can be unleashed when the trust – between consumers and the firms that serve them – is broken.

In 1873 the eminent British essayist Walter Bagehot put this way: ‘The peculiar essence of our financial system is an unprecedented trust between man and man; and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.’

In the new frontier of innovation this carries more resonance than ever.

As governments and regulators around the globe begin to set up their own innovation units and sandboxes, we believe it is vital that standards are maintained.

A free-for-all, where consumer protections are jettisoned in the pursuit of the most innovative or lucrative product, is in no one’s interest. And, aside from the reputational damage it will cause, that approach will not foster firms that succeed long-term.

In a connected world, failure in one location presents risks to all.

Through bodies like the G20 and IOSCO, we are working with international partners to build consensus around the principles of good innovation.

Responsible innovation should enhance outcomes for consumers, not diminish them.

And we’re confident that a regulator’s approach can be both progressive and protective.

Going forward

The products we see coming through our sandbox are at the very cutting edge of the industry.

But as advanced as today’s innovations are, their success still relies on trust - the ‘peculiar essence’ described by Bagehot all those years ago.

This sits at the intersect between the two cornerstones of our approach: competition and consumer policy.

When these two work together a ‘virtuous circle’ occurs: firms enter, innovate and compete hard to meet consumer needs, while engaged, informed consumers distinguish between good deals and bad, and vote with their feet accordingly.

And it is regulation that can give consumers the confidence to participate in the first place.

Putting consumer protection front and centre of our innovation agenda doesn’t mean stifling innovators.

Quite the opposite. As I hope I’ve demonstrated, the FCA’s approach is progressive and proportionate. And we will always be a friend to firms from around the world who are innovating in the interests of consumers.

We’ve come a long way since that speech in 2013 and I’m excited to see how much further we can go.

Thank you.