The role of regulation in encouraging good culture

Speaker: Andrew Bailey, Chief Executive
Event: Investment Association Culture Conference, Mansion House, London
Delivered: 6 November 2018
Note: this is the speech as drafted and may differ from the delivered version

Highlights

• The effectiveness of communication with consumers is in my experience a test of culture.
• This is an area where we are asking a lot of individuals, and so it is reasonable that they will want to put their trust in experts who can assist with advice and guidance on decisions on saving and investment.
• I would argue that an industry which enables the support of patient capital and innovation, and of ethical investment and social responsibility, will be one where the trust will be stronger and deeper, and the culture will prosper.

Thank you for inviting me to speak at the Investment Association Culture Conference. I want to start with a couple of individual notes. The first is to thank the Lord Mayor for his leadership during his term in office, and particularly for his championing of trust in financial services for which he has given very vocal support. In so doing, I would guess he has been the first Lord Mayor to do a series of podcasts, or interviews with people to get to grips with what is a perhaps surprisingly elusive subject, namely the meaning of trust.

The second individual note is much sadder I’m afraid, because at the weekend we lost someone who has embodied the importance of personal trust in our State and in our public life. I am talking about Jeremy Heywood, whom I first met around 30 years ago. I have to be honest that there are few people for whom I can say with precision where I first met them that long ago, but I know for sure with Jeremy that it was in the IMF canteen in Washington. He was working as part of the UK Delegation and I was visiting from the Bank of England, and we were both engaged on the problems of the 1980s debt crisis in developing countries.

In the intervening period our paths crossed on a diverse range of subjects, and it was always clear to me that Jeremy cared deeply about our public life. We were lucky to have him playing such an important role and we will miss him dearly.

I think I can be pretty confident that Jeremy would have agreed that the answer to the role of regulation in encouraging good culture is not to make a rule to say as much. It wouldn’t work. That’s a very narrow view of regulation. In the traditional world of regulation, rules act as prescriptive statements that forbid, require or permit some action or outcome – thus forbidding, requiring or permitting must be present in a rule.

That’s a pretty fair description of rule-making. And it follows – by assumption I would say - that if you can make enough rules, and of course the right ones, the culture will be good, and trust will be built and maintained. The problem is that in practice a set of rules tends to underdetermine what needs to be done – it is unlikely that a rulebook will be able to predict and determine every situation that a regulated party can face, and in any event we want to see a world in which regulated parties are encouraged and incentivised to exercise their own judgment reliably and regularly, drawing on their own competence and honesty.

So, to the verbs of forbidding, requiring and permitting, I would add enabling, encouraging and incentivising as important tasks of the regulator.

I want to talk today about how these approaches can help to tackle the difficult issues of culture and trust, with particular reference to investment management. But let me start with a whistlestop tour of why investment management matters in this context.

Investment management

Assets under management in the UK’s investment management sector grew to £9.1 trillion in 2017, up from £8.1 trillion in 2016.

Around 20% of assets under management is managed for retail investors, with the other 80% for institutional investors. But, of course, behind that 80% are often individuals. A quarter of all assets under management are now passively managed, and the share is continuing to increase. In 2017, net retail flows into UK funds were over £47 billion compared to £7 billion in 2016. And, when we look at the situation in a European context, we see that in 2017 the UK had around 35% of assets under management in Europe, compared with 10% in France and 9% in Germany.

The aggregate numbers are large, but it is important to remember that they often represent the long-term savings of individuals who are trusting that this will provide a comfortable retirement. And this is increasingly so, because over time the responsibility for retirement saving has been transferred from employers to individuals, and of course with that has gone the risks involved in such saving. More recently, choice for individuals has also been opened up in what we tend to call the decumulation stage – drawing down retirement savings. This is an area where we are asking a lot of individuals, and so it is reasonable that they will want to put their trust in experts who can assist with advice and guidance on decisions on saving and investment. And this brings into play the culture and behaviour of those in whom trust is placed, the investment managers and advisors – so, the stakes are high, and getting higher I would say. Probably around three quarters of households in the UK are direct or indirect customers of investment managers. To be frank, this activity is no longer the preserve of the wealthy – it is central to the financial wellbeing of most people in this country.

So, what could possibly go wrong? When looked at in aggregate, this does not appear to be an industry which is short of competition when judged by the number of participating firms.

This has not always been so when we look at some of the other sectors we regulate. And yet, we could see issues which appeared to be creating harm for consumers. This came more sharply into focus with our Asset Management Market Study, which highlighted a lack of transparency in terms of charges levied by managers, and fund objectives failing to provide investors with a clear indication of what they were doing. We are currently working with firms and with the Investment Association to implement a series of remedies that have come out of the market study.

This is all for the good I am sure, but I want to draw out some of the broader issues raised, and how these can affect culture and trust. I want to start with the issue of transparency and particularly around the question of fees and charges. One of the very clear findings from our work was that investors were often disengaged from what they were paying in fees and charges, and thus the impact on their savings, and particularly that over the long period to which such contracts cover, even smallish differences in cash and charges can have a large effect on the total pot.

The answer will often be given as more transparency and disclosure. And, of course, that is a good thing. But transparency on its own is not enough. It has to go along with effective communication. This is an important point, and something we see commonly in our work with firms and sectors, namely that the answer to information problems is not just to present more and more of it and then wonder why the consumer does not respond with clarity, and behaviours do not change, at least to the predicted degree.

The effectiveness of communication with consumers is in my experience a test of culture.

It is not uncommon for cultures to tend towards complacency, to rely on a favourable indicator or two and thus downplay many others which are not positive, or to rationalise that when issues come up they must not be systematic problems because only a few cases have been identified. You can call this a lack of curiosity. It is an important point for firm and fund governance, and why we have made the case for a stronger independent director presence in asset management governance, so that there are people involved who can ask the difficult or challenging question. Good culture supports this, and in my view the role for regulators is as much to encourage it as it is to require it.

It comes back to my earlier point that on their own rules alone will underdetermine what needs to be done to produce robust outcomes in the interests of users and consumers.

Interestingly, this points to one of the eternal debates in our world, about the differences between regulation and supervision. The two terms are often used almost interchangeably, wrongly so. Regulation is a broad term that arguably covers everything we do, but it tends to be focussed on rule-making and the formal enforcement of those rules when things go wrong.

Supervision is about us exercising judgment based on the framework of rules, to get the outcomes we want to see consistent with our public policy objectives. We undertake both regulation and supervision, with the latter essentially firm based. This is the model that emerged in UK financial services really in the 1970s and 80s.

But, we are now expanding our approach, both to reflect the FCA’s role as a sectoral competition regulator, and also to push forward our commitment to enabling change to occur through a variety of approaches. Most prominent here is our work on innovation and technological change, our Project Innovate and our Sandbox. This by the way is a sea change in our culture, because it shifts the debate from one about regulation as a means to forbid, require or permit, to one where we enable change to occur, subject to that enabling being consistent with our public policy objectives and to the fact that we are not in the business of picking winners – enabling is a very different thing.

We look forward to the imminent announcement of the launch of an independent group to take forward the existing work, supported by ourselves and industry bodies including the Investment Association. This is designed to improve cost transparency for institutional investors.

From a cultural perspective, I look forward to enhancing not just transparency but, more powerfully, more effective communication between investors and managers.

Ethical investment

Let me finish with another very powerful example of an area of activity for investment management which I have no doubt will have an important impact on trust in the sector and thus on culture. The bare statistics show that the proportion of passively managed assets continues to increase steadily, with around a quarter of all assets under management now passively managed.

The reasons for this trend have been very well rehearsed and I am not going to add to that commentary. Instead, I am going to highlight the developments going in the opposite direction.

The 2017 Mintel Equity Investing UK report indicated that 54% of respondents believed ethical investment is important, up from 39% the previous year. At the FCA we are consulting on rule changes to require the Independent Governance Committees of contract-based pensions to report on how they manage environmental risks in their investment strategies and how they take into account the ethical concerns of investors.

The Government has also agreed to clarify that trustees have a fiduciary duty to consider long-term risks and opportunities. It is consulting on amendments to pension scheme regulations that would oblige trustees to outline how they take account of financially material risks and opportunities including climate change considerations. The Government has also agreed that it is good practice for pension scheme trustees to inform the design of investment strategies with an understanding of the views and preferences of their members.

Separately, in the Budget last week the Chancellor announced a plan to unlock finance for innovative high-growth firms, and established a taskforce to address the barriers to pension funds investing in so-called patient capital. The FCA will publish a discussion paper by the end of this year to explore the impact of the UK’s existing fund regime on investment in patient capital and we will consult to update the permitted links framework to allow unit-linked pension funds to invest in an appropriate range of patient capital assets.

There is an interesting bigger picture story going on here, which can seem contradictory but doesn’t need to be.

A longer-term shift towards passive investing goes alongside a desire for more ethical and socially responsible investing and a desire to encourage longer-term patient capital. Of course, these two developments can co-exist. Indeed, I would go so far as to say that they will, and that in doing so there will be some re-clarification of the meaning of active investment.

An interesting point here is that in terms of trust and culture, it will I think be a good development.

Passive investment suits the needs of a lot of investors, at least in part. But it can co-exist with a world where investors also want to express a preference which embodies their values and longer-term goals, with ethical objectives for instance. And, I would argue that an industry which enables the support of patient capital and innovation, and of ethical investment and social responsibility, will be one where the trust will be stronger and deeper, and the culture will prosper. And, the regulator can help by enabling change to happen.