To what extent is the regulatory approach relevant, in improving regulatory outcomes of fairness and transparency for the benefit

of the consumer and society as a whole, in light of the lessons to be learnt from the credit crunch?

Assignment for Financial Regulation and Conduct Course

By: Lilian Miringu i7819821 MBA (Part-time student) The Business School Bournemouth University

Date of Submission: 11th June 2010

TABLE OF CONTENTS
1. INTRODUCTION ....................................................................................................................................................................2 2. REGULATORY APPROACH PRACTISED IN THE UK .................................................................................................3 3. ANALYSIS OF PRINCIPLE BASED REGULATORY APPROACH.................................................................................4 3.1. Key Characteristics of the Present System of Regulation.................................................................................................4 3.1.1. Intensive Risk Focused Supervision...........................................................................................................................4 3.1.2. Participatory and Conversational Approach ..............................................................................................................5 3.2. Justification and reasons of adopting U.K. approach to regulation....................................................................................6 3.2.1. Self-Regulatory Regime.............................................................................................................................................6 3.2.2. Conducive for Innovation and Competition...............................................................................................................7 3.2.3. Principles More Effective As Opposed To Rules.......................................................................................................8 3.3. Deficiencies of Principle Based Approach to Regulation..................................................................................................9 3.3.1. Compliance Enforcement Challenge .........................................................................................................................9 3.3.2. Lack of Clarity...........................................................................................................................................................11 3.3.3. Risk of Regulatory Capture......................................................................................................................................12 4. TCF IS AN OPPORTUNITY TO EMPHASISE AN ETHICALLY BIASED REGULATION ...........................................13 4.1. Treating Customers Fairly................................................................................................................................................13 4.2. Significance of Ethics in Financial Services Industry.....................................................................................................14 4.3. Framework for Ethics Based Regulation..........................................................................................................................16 4.4. Determinants of Success for an Ethical Framework........................................................................................................18 4.4.1. Compliance Competence...........................................................................................................................................18 4.4.2. Consumer Protection through Education and Public Awareness..............................................................................19 4.4.3. External Auditors Are Crucial..................................................................................................................................20 4.4.4. Lessons from Islamic Finance..................................................................................................................................22 5. CONCLUSION.......................................................................................................................................................................24 6. APPENDIX.............................................................................................................................................................................25 7. REFERENCES........................................................................................................................................................................25

1. INTRODUCTION
Continual innovation of financial products to achieve increased sales and market conquest may have resulted in the significance of the consumer being under rated, yet they determine the success and growth of these financial institutions. Customers and other stakeholders should be seen as partners in the process of developing company wealth, not as the means by which one develops it (Metcalfe, 1998).

Financial institutions also have fiduciary responsibility to act in the best interests of the consumer, while regulation and supervision of financial markets should enhance trust in financial institutions and in the financial system. The recent global credit crisis raises concern whether regulation enough to ensure that financial institutions act responsibly. This essay critically discusses the regulatory approach currently applied in the U.K. to regulate financial services and its relevance in improving outcomes of fairness and transparency for the benefit of the consumer and the society in the light of lessons the credit crunch.

2. REGULATORY APPROACH PRACTISED IN THE UK

UK has a single regulator, the Financial Services Authority (FSA) across all business lines which ensures consistency of regulation between economically similar activities, whether characterized as banking, broking, insurance or otherwise (FSA, 2009). It is also well placed to deliver effective, efficient and properly differentiated regulation (Briault, 2002). However as a caution, Goodhart et al (1998) suggest that a single regulator may lack clear focus on the objectives and rationale of regulation1. Although both conduct of business and prudential regulation are carried out by the FSA, (FSA, 2009), conduct of business regulation is emphasized (Edwards and Wolfe, 2005). Goodhart et al (1998) believe that the main aim of conduct of business regulation is to establish rules and guidelines about appropriate behaviour and business practices in dealing with customers, as FSA have done with their handbook which has 11 principles of business to guide in the conduct of business.

1 The need for a single regulator which regulates the banking sector, the insurance and securities sectors, was necessary because of the rise of conglomerate firms. Single regulators are able to manage more effectively across sector services' risks. Correspondingly, the functional overlaps between banking, insurance and securities business and their universal scope make it more difficult for a regulator to observe and comprehend such businesses (C. Goodhart 1998).

Though the FSA is termed a principles-based regulator,2 a study of its operations revealed that there are a number of connected but distinct regulatory approaches working under the banner of principles-based regulation (PBR), some of them suggesting potentially radical developments in the relationship between the FSA and the industry it regulates (Black et al., 2007). 3 Currently, PBR focuses more on the outcomes to be achieved, requiring greater engagement by the regulated community and leaving more of the decision calls on how to achieve those outcomes to the senior management of the firms (FSA, 2007, 2010). This shift towards outcomes-focused regulation and making judgments about judgments implies that the FSA now has more interest in senior management responsibility and oversight than it did before. Therefore the consequences of negligent or reckless compliance failures within a firm will cause the FSA to use its enforcement focus towards those individuals that hold Significant Influence Functions within firms (Nattrass,2009).

3.
3.1. 3.1.1.

ANALYSIS OF PRINCIPLE BASED REGULATORY APPROACH

Key Characteristics of the Present System of Regulation Intensive Risk Focused Supervision

The Supervisory Enhancement Programme has been termed intensive supervision and involves increased resources devoted to supervise high impact firms with an increased frequency of comprehensive risk 2 The FSA considers that there is such an intimate link between high-level principles and the detailed rules that surround them, so that in one of his recent speeches Callum McCarthy, the Chairman of the FSA, pointed out that it is misleading to characterise the FSAs regulation as principles-based. Taking into account that there are currently 8500 pages of rules, the FSA could equally . . . be described as rule bound regulator: C McCarthy Financial Regulation: Myth and Reality FSA Speech (13 February 2007). 3 PBR is a complex form of regulation and it takes different forms in different contexts, countries and regulatory domains (tax, securities, accounting, health). Julia Black (2008) in the article Forms and Paradoxes of Principles Based Regulation identifies four forms of PBR: formal PBR, substantive PBR, full PBR and polycentric PBR.
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reviews (ARROWs).4 Focus has also changed from systems and processes, to key business outcomes, risks and on the sustainability of business models and strategies (FSA, 2009). Baldwin and Cave (1999) noted that the first challenge faced by regulators is in identifying the risks that need to be reduced on the basis of priority and in a way which would be approved by the public,5 because theres an emphasis in consultation with the public and industry (Ford, 2007).6 The risk-based framework increases flexibility because it allows the FSA to apply and enforce rules in a manner that is proportionate to the risks7 that each regulated firm individually or the market as a whole imposes upon the regulators activities (Georgosouli, 2008).

3.1.2.

Participatory and Conversational Approach

FSA is in constant communication and dialogue with the regulated firms to ensure that its regulatory requirements are properly understood. Implementation of the Treating Customers Fairly (TCF) initiative offers a standard example of methods that the FSA uses to communicate with the regulated population (FSA, 2006). Conversational components provide a forum of debate and scrutiny of the FSAs policies. They clarify the uncertainty of fulfilling a range of broadly defined and frequently conflicting regulatory

4 This risk-based

approach ascertains the risks posed by the companies themselves and their investment business activities, and identifies current and potential problematic investment business themes across the sector EDWARDS, J. & WOLFE, S. (2005) 5 Stewart (2005) keenly cautioned that the effectiveness of risk-based regulation depends on the regulated agreeing with the regulators about what risks need to be controlled and the manner of control.
6 The formation, application and enforcement of rules

are currently guided by the ARROW II framework which provides a common risk assessment framework for all regulated firms while providing a regulatory approach that is proactive, integrated and transparent GEORGOSOULI, A. (2008). 7 ARROW II framework identifies three sources of risk namely; the external environment, the consumer and industry-wide risks, and the regulated customers themselves HITCHINS, J., M;, H. & MALLETT, D. (2001) Banking: A Regulatory Accounting and Auditing Guide. Institute of Chartered Accountants..
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objectives while defining complex problems where the consequences of regulatory action are hard to appraise (Georgosouli, 2008)8. In some circumstances, relevant FSA guidance has been formulated in conjunction with industry itself. For example, in 2004 a group of four trade associations published industry guidance on their understanding of the FSAs rules with respect to trading ahead of investment research. The FSA in turn publicly confirmed that the guidance was consistent with the regulators intent FSA (2005). These conversational elements in the policy of rule use are evidence that the FSAs formation, application and enforcement of rules are done through the intervention of interpretive communities (Black, 1997).9 Nonetheless Julia Black points out that rules need a sympathetic audience if they are to be interpreted and applied in a way which will further the purpose for which they were formed, thus the rule maker and the rule applier are in a reciprocal relationship (Black, 1997).10

3.2. Justification and reasons of adopting U.K. approach to regulation 3.2.1. Self-Regulatory Regime

FSAs PBR framework originated from the self-regulatory regime that was adopted under the Financial Services Act 1986 which employed high-level principles and rules to govern the practices of their members. The FSA intended to be market-friendly without prescriptive rules to avoid London losing its leading position as an international financial centre. Baldwin and Cave (1999) support FSAs stand 8 For instance the FSA does not prescribe the specific examinations that individuals engaged in particular financial sector activities must pass, instead firms choose from a list of examinations based on what they believe is appropriate to their circumstances FORD, C. L. (2007) New Governance, Compliance, and Principles-Based Securities Regulation. American Business Law Journal.
9 Interpretive communities

are fundamental to a principles-based system because they are mechanisms that allow regulators to communicate with industry about their expectations, and allow and require industry to speak openly and regularly with regulators about their processes while functioning transparently and predictably BLACK, J., HOPPER, M. & BAND, C. (2007) 10 Firms also need to be well intentioned to facilitate a co-operative and educative approach to supervision. Ibid.

because they believe that self regulators are able to acquire information at lower costs, incur low monitoring and enforcement costs and can easily adapt their regimes to changing industrial conditions. Therefore the FSA continued with the PBR approach, which became an FSA regulatory objective to continue developing PBR in the UK (FSA 2007).

3.2.2.

Conducive for Innovation and Competition

It is important that regulation can respond rapidly to the pace of change in markets and so allow them to continue to develop for the benefit of their users. Regulation that focuses on outcomes rather than prescription is more likely to support this development and innovation (FSA, 2006). By being outcomeoriented, PBR recognizes that there may be more than one means through which to achieve a regulatory goal thus establishing a more direct relationship between regulatory goals and requirements in order to make more efficient use of regulatory and industry resources.11 PBR ensures a stronger probability that statutory outcomes are secured while giving more stimulus to competition and innovation (Ford, 2009). At the same time, PBR offers effective protection as senior managers drive the changes necessary for their firms to honour the principles (FSA 2007).12

11 The chief executive officer of the London Stock Exchange, Clara Furse, argued that Londons Principles based regime continues to prove itself as a model that facilitates pro-competitive innovation in a tough but sensible regulatory environment. All the important independent corporate governance surveys show that the U.K. is number one for corporate governance standards. Clara Furse,Comment: Sox is Not to Blame, London is Just Better as a Market, FINANCIALTIMES (U.K.), Sept. 18, 2006, at 19 12 This is because principles offer flexibility for regulated firm and regulator in determining how to comply with the rule, facilitating the development of new business models, products, strategies and internal processes BLACK, J., HOPPER, M. & BAND, C. (2007) Making a success of Principles-based regulation. Law and financial markets review, 1, 191-206.

3.2.3.

Principles More Effective As Opposed To Rules

Briault, (2005) affirmed that principles result in senior management interprating for themselves what TCF means by carrying out a gap analysis to identify areas of their business where they are not meeting the obligation to treat customers fairly. Consequently they formulate strategies to address the gaps, set clear priorities and targets, to determine how progress will be tracked (Edwards, 2006). Therefore principles lead to more substantive compliance with the purpose of the rule, rather than a checklist approach because firms think through ways of complying (Black et al., 2007). However, there are arguments that what the industry needs is the certainty provided by a detailed rulebook because without this, financial firms would constantly be worried that the regulator may pursue them for some unintended offence.13

Goodhart, et.al.(1998) argue that there is always an inherent danger of over-regulation because consumers perceive regulation to be a costless activity and therefore it is over-demanded, while regulatory agencies are mostly risk-averse thus posing the possibility that regulation may be oversupplied. However, what matters ultimately is the intent of the people who have been entrusted with the custodianship of out financial assets. With stretching targets to be achieved and the possibility of riches to be made, risky behaviour and market misconduct may become persistent evils to dealt with.14

13 In response, Davies H. (2001) argues that those who reason like this are either those in senior management who believe that given the extravagant profits to be made in financial markets and the manifold temptations to which their people are exposed, that they can more easily manage the business and achieve compliance if there is a detailed rulebook which they can monitor. On the other hand, those who seem to want a detailed rulebook may occupy their minds in finding ways around it DAVIES, H. (2001) Ethics in regulation. Business Ethics:AEuropean Review, 10. 14 For instance, what has emerged as a lesson from the global credit crisis is that premising banking regulation on
disclosure and market discipline was a flawed approach that endangered the stability of the global financial system. Disclosure is effective in banking regulation only as a supplement to strict protective rules that limit the kind of activities an institution may undertake and restrain its risk-taking appetite AVGOULEAS, E. (2009) What Future for Disclosure as a Regulatory Technique? Lessons from the Global Financial Crisis and Beyond.

3.3. Deficiencies of Principle Based Approach to Regulation 3.3.1. Compliance Enforcement Challenge

Black et al (2008) found that the FSA has been accused of not being enforcement led because of seeming to promote early settlement with offenders, thus avoiding harsher rules-based enforcement with jail at the end. It was also noted that the headcount of its enforcement division has reduced from 250 to 200. Therefore Black et al (2008) reckon that any reduction in UK insider dealing may turn out to be attributable to the ripple effect of harsher US enforcement.15 Maybe the FSA needs to be more aggressive in policing the financial services industry to ensure compliance because prescriptive standards have been unable to prevent market misconduct in the past.

In the past the FSA has been accused of wanting enforcement procedures due to sub-standard investigation work, bias and lack of transparency. The enforcement process review issues paper accused the FSA of failing to always prosecute based on an adequate and thorough investigation and for using staff with inadequate knowledge of the industry and using retrospective regulatory standards. (Salmon 2005). This lack of transparency by the FSA may have caused standards of business ethics to slip. If the regulated community lacks confidence in their regulator, it may result in the detriment of moral in the businesses which in turn affects how consumers are treated. Eventually a vicious cycle results and the task of getting the standards back up again becomes a challenge.

15 Regulators under a PBR system may be more prone to encounter what we may term the supervisory and
enforcement paradox if there is little internal appetite or little external political support for strong enforcement action. Principles have to be enforced to give the regime some credibility, particularly in the face of criticisms that they signify a weak regulatory regime. Conversely, tough enforcement has its drawbacks and may raise hostility to the regulatory regime (Black, 2008).

However, legislation alone is not sufficient to ensure consumer protection as compliance needs to be monitored and enforced (Kempson, 2008).16 Consumer protection agencies and the ombudsman may need enforcement powers so that the financial services companies are kept on their toes. Naming and shaming the culprits would also serve to deter mismanagement and ensure that the fiduciary duty owed to consumers is upheld. Did the regulatory system fail the consumers due to a weak enforcement system?

Furthermore, FSA has been accused of operating under a culture of secrecy and failing customers by not being bold enough in tackling misleading advertising and poor customer service. Which? criticised the FSA for not identifying firms which put out misleading financial adverts or perform poorly in mystery shopping exercises, and they believe that practice will only improve when those who fail to treat their customers fairly suffer damage to their reputation and bottom (Which? 2008). Although the FSA is said to have agreed to publish general statistics on the number of complaints companies receive, it is still adamant in naming and shaming companies that breach its rules. Although FSA insists that it operates under a strict legal framework, the Financial Services and Markets Act, which prohibits the disclosure of certain information, the consumer and society at large still have the right to know which companies put out misleading advertisements or perform badly in mystery shopping exercises(Turner 2008) . If this cannot be done, then how else will FSA purport to be upholding and promoting fairness and transparency? Or is the FSA a victim of regulatory capture, which would imply that the battle for fairness and transparency is futile? 16 This is illustrated in the case of Equitable Life scandal where the policyholders have not been compensated in the 10 years since Equitable collapsed, in which time 30,000 of them have died. The Treasury resisted the recommendations of parliamentary ombudsman Ann Abraham, who wanted an independent tribunal to assess claims quickly and simply, working out their losses by looking at what they could have earned if they had gone to an alternative company OBSERVER, T. (2010) Fresh political battle looms over Equitable policyholders. Guardian.. Justice delayed is justice denied. Had the FSA been stronger in enforcing compliance, transparency and fairness would have been prevailed to protect the consumers assets. In addition, the auditors should have noted any anomalies before the insolvency.

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3.3.2. Lack of Clarity In meeting requirements of the TCF initiative it has been unclear for many firms what exactly is expected of them by FSA, as the majority argue that they already treated their customers fairly.17 Firms apprehended the costs and challenges that would arise while demonstrating to the FSA that they had treated their customers fairly and engaged with the TCF process (The Financial Services Practitioner Panel, 2006/7) This may have been caused by the fact that principles require more analysis in their application, which can result in complexity (Black et al., 2007).18 Making matters worse is the criticism that the FSA website is an absolute disaster to navigate," to quote a London-based regulatory partner. The critic finds the website colossal, ill-arranged, practically unsearchable array of material, all of which is relevant to how the applies its rules. This is significant as lawyers find it difficult to keep up with policy issued through discussion papers, speeches, 'Dear CEO' letters, thereby keeping lawyers occupied full-time just to keep up with what FSA does. This challenge ultimately affects transparency which is critical if the regulator and the regulated community are supposed to work in partnership to avoid another credit crisis (N.P. 2008).

17 PBR can hinder communication in practice: a communicative paradox. This can arise if there is a proliferation of guidance, for instance the FSAs development of PBR, where elaboration on the scope and implementation of TCF, comes in a plethora of speeches, policy documents and miscellaneous communication documents. This verbal outpouring by the FSA makes it hard for regulated firms to know just what the FSA is requiring of them and produces uncertainty as every speech by an FSA official is scrutinised by compliance officials and their legal advisors for the slightest hint of changes to the FSAs approach (Black, 2008). 18 Furthermore, complexity of the FSA handbook structure may affect communication between regulators and the regulated. Numerous provisions in the form of guidance, some of which are legally binding, while others are not, leaves the regulated community struggling to decode how each of them interacts with highlevel principles and how they define the parameters of compliance GEORGOSOULI, A. (2008) The nature of the FSA policy of rule use: a critical overview. Legal Studies, 28, 119139..
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However, it has been noted that industry guidance19, high-quality FSA staff and targeted, clear communication programmes, like the TCF Aide Memoire, provide remedy by addressing a number of the concerns held by practitioners over principles-based regulation (The Financial Services Practitioner Panel, 2006/7).

3.3.3.

Risk of Regulatory Capture

Research has found that the conversational character of the FSA regulatory approach is more likely to be a dialogue between the enforcement officials and the regulated firm. Therefore the capacity of the rest of the regulated population to monitor the regulatory process and hold the regulator accountable becomes increasingly frail. Furthermore, conversational patterns of regulation are more likely to increase the cost of regulation rather than reduce it (Black, 1997). Not only do they require the maintenance of complex networks of communication and sophisticated fora of deliberation but they also create conditions that render decision making particularly vulnerable to regulatory capture (Georgosouli, 2008).

The external auditor would help in avoiding the risk of regulatory capture by being an intermediary between the FSA, market and consumers. Many questions have been raised in relation to the FSA's ability to be held accountable given the all embracing nature of its role and concentration of powers. Such questions include whether the FSA could be made sufficiently accountable to industry whilst avoiding regulatory capture, whether it could be made properly accountable to consumers without creating false perceptions and possible moral hazard concerns about the extent to which the regulatory system would 19 Guidance performs various functions including the clarification of the form and manner of compliance, the development of market-based solutions to market failure and the overall maintenance of communication between the FSA and the regulated population.FSA Better Regulation Action Plan (December
2005) p 6 and J Tiner Better Regulation: Objective or Oxymoron? FSA Speech (9 May 2006) p 4-5

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protect them from financial risks and the mechanisms in place to hold it politically accountable since it is independent of government OJO, M. (2009b).

External auditors contribute to the supervisory process and therefore it would help to implement a law like that of Sarbanes Oxley in Britain. If it was implemented in Britain, it would discourage the dual role of auditors and reporting accountants/skilled persons thereby encouraging greater use of external auditors within the financial supervisory process. As a result the quality and accuracy of financial reporting would improve while raising awareness of internal controls and strengthening the independence of audit firms (Ojo, 2006). Levine (2003) observed that to increase market discipline, accounts and internal controls need to be reliably audited according to international accounting standards. This would result in increased transparency and fairness.

4. TCF IS AN OPPORTUNITY TO EMPHASISE AN ETHICALLY BIASED REGULATION

4.1. Treating Customers Fairly TCF can be a starting point for the FSA to mandate financial services firms to review their business in terms of an ethical approach20, which in turn would require them to consider organizational cultural change. The FSA confirmed that its regulatory approach driven by the FSMA is values based (Edwards, 2003).21 To establish an ethical approach to the business activities of the firm, it is necessary to adopt the right 20 The credit crunch was caused mainly by a failing of governance and ethics than of regulation. Therefore making changes to the mechanics and structure of regulation will not avoid a repeat of another credit crisis. The financial services industry cannot rely on regulation alone ACCA (2009) The Future of Financial Regulation. The Association of Chartered Certified Accountants.
21 This is evidenced

by the fact that the FSA believes it is essential for senior managers and the board to treat TCF as a strategic issue by embedding TCF into the firms culture EDWARDS, J. (2006) Treating customers fairly. Financial Regulation and Compliance, 14, 242-253.

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corporate culture22. The culture of an organisation drives the behaviours of its management and staff and their actions, which in turn determines the outcome for consumers (Mullineux, 2006). The FSA already ensures that the TCF initiative comprises of voluntary agreed codes of practice and internal controls to reflect the responsibility of financial institutions not to exploit customer's ignorance (Llewellyn, 2005), as it is impossible to generalize since the financial services sector is a huge and diverse market. To this effect, Edwards (2006) enunciated that the interpretation of the term fairness is flexible and relative, implying that adopting a procedural checklist approach to TCF would not help.

FSA research revealed that around half of adviser firms are failing treating customers fairly in the way that they draft contract terms for clients. The regulator reviewed 60 contracts and found that 32 failed on TCF. The research found that most firms say they have systems and controls in place to review the fairness of contracts but they are not always compliant with TCF (Blackmore, 2008). This stresses the significance

of changing corporate culture and emphasizing the value of businesses adopting an ethical approach to their strategies in order to improve fairness and transparency. If a company would incorporate ethics in all its strategies, including induction and training of new employee, then TCF would cease to be such a challenge. 4.2. Significance of Ethics in Financial Services Industry

Ethical behaviour in the financial industry is important as financial decisions involve other people's money and accumulated wealth. It is impossible to develop and impractical to implement, for every possible contingency in the financial industry, rules of behaviour constraining self serving behaviour or behaviour

22 Schein (1985) defines corporate culture as a pattern of basic assumptions that have been invented, discovered or developed by a given group as it learns to cope with its problems of external adaptation and internal integration.

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favouring certain stakeholders. Laws, regulations, and corporate rules of conduct consequently leave many details undefined, and the players have to look for guidance to commonly accepted values and morals as reflected in social expectations of ethical behaviour (Aggarwal, 2010).

In March this year, the FSA charged seven people with insider trading in relation to information obtained from two investment banks. The accused are alleged to have amassed unlawful profits of about 2.5m over a two-year period (BBC, 2010a). Although FSA did not name the two investment banks affected, this kind of unethical behaviour in finance generally has a contagion effect. Even for firms not directly associated with unethical behaviour, it can lead to higher operating costs for all businesses in that industry due to the increased regulatory and legal actions designed to curb such behaviour (Aggarwal, 2010).

Adopting an ethical approach is consistent with the partnership approach being advocated by the FSA and businesses would have freedom to develop their own values and beliefs, which are more likely to be accepted by its employees.23 Nonetheless, the ethical approach has to be comprehensive to include the

23 An appropriate ethical culture is an intangible set of values, beliefs and rules of behaviour, which are part of the social glue of the organisation. Unlike rules that tell you how to act, ethics tell you how to think before acting. The appropriate ethical culture should result in the organisation and its employees demonstrating professional standards of integrity, honesty, fairness and responsibility (Baker, 1980).

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wider stakeholders, involve top management and be fully integrated into the organization. It should be owned by everyone, evidenced in the day-to-day operation of the company and form the basis of individual and corporate assessment of personal and organisational goals (Edwards, 2003). Companies therefore need to focus upon their actions and those of their agents and employees to make sure that they act ethically and consider customers views in all matters (Wood, 2002).

4.3. Framework for Ethics Based Regulation Edwards (2006) recommended that FSA should have a system of monitoring and testing that customers are being treated fairly by the firm throughout the product life cycle. This would be accomplished by integrating the TCF policy into the culture, systems and controls of the firm.24 It would also be made effective by emphasizing its significance in day-to-day operations and employee behaviours.25 Jackman (2001) proposed that ethical corporate culture would reduce the need for intrusive regulation because development of value systems beyond mere compliance standards would help prevent behaviour becoming unacceptable.26

24 Regulation is society's attempt to develop and externalise shared values and frameworks. It involves having a common discipline, focus and outcomes rather than following inflexible rules. For this to work, tools and frameworks are needed which would provide the FSA and the industry with means to achieve a clear purpose and outcome JACKMAN, D. (2001) Why comply? . Financial Regulation and Compliance, 9, 211-217. 25 TCF must be part of new employee induction, the subject of staff development programmes linked to staff performance and annual reviews that have the incentive of appropriate reward structures (Edwards 2006). 26 . Ethics based regulation involves improving integrity, honesty, fairness and responsibility and changing the attitudes and approaches of individuals and cultures (Jackman, 2001).

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On the other hand, Wood, (2002) offers a broader and more elaborate ethical model (See figure 1.) which focuses on the development of an appropriate ethical culture arising from the firms internal commitment to change supported by a wide range of stakeholders (Edwards, 2003).27 The financial services sector has an increasingly difficult task balancing the demands of a lengthening list of stakeholders (shareholders, the community, investors and pressure groups, regulators). This has resulted in the sector being subjected increasing public scrutiny (FSA, 2002). The wood framework of ethically based regulation seems to be most suitable to balance the needs of these stakeholders.

The sentiments and views of stakeholders are important to any company because they are affected by the success and failure of the company (Heath and Norman, 2004). Although stakeholders are not present during the day to day operations of the company, they can nonetheless impact on the reputation of the company. It is vital to ensure that stakeholders view the company as a positive force for the society and that they deem the organization to be an acceptable purveyor of its products. Excluding stakeholders in business plans and strategies may be is an invitation for trouble in the future and ignoring them is a recipe for disaster (Svensson and Wood, 2008).

27 Edwards (2006) proposed that Woods (2002) ethical-based corporate partnership model provides a valuable insight for the practical and organisational processes and structures required of an ethical framework within which TCF would flourish.

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4.4. Determinants of Success for an Ethical Framework 4.4.1. Compliance Competence Jackman came up with a model of compliance competence,28 which seeks to develop the correct corporate values and culture based upon an appropriate ethical approach. This model suggests that an ethical approach to business is the way forward, not just to meet the regulator's aim of compliance competent organisations, but also to benefit the regulated with an improved public image, a better business and a lighter regulatory touch from the FSA (Edwards and Wolfe, 2006).

On the other hand, Newton (1998) argued that firms should adopt an ethical culture in which the values underpinning regulation have been specifically accommodated rather than a compliance culture. However, Edwards (2006) cautions that in order to be compliance competent,29 businesses should adopt an ethical approach to their business strategies thereby meeting the regulator's aim of sustainable regulation.30 28. Compliance is core to the operation and well-being of the financial services sector and the consumer, especially in the way they carry on their investment business and comply with the conduct of business requirements set out in the FSA Handbook. Compliance includes concepts of obedience, observance, deference, governable, amenable, passive, non-resistance and submission. Linked to this are aspects of duty that include doing what ought to be done, moral obligation, accountability, propriety, fitness, to be on one's good behaviour, answerable, to act morally and ethically . Competence on the other hand raises issues of appropriate qualifications, an ability sufficient for the need, proficiency, accomplishment, capability, conversant, experienced, schooled and practiced EDWARDS, J. & WOLFE, S. (2006) A compliance competence partnership approach model. Financial Regulation and Compliance, 14, 140-150. 29 The potential ethical paradox is that PBR can facilitate the development of ethical approaches to compliance, but the greater interpretive risk that it imposes on firms may mean that ethics become compromised. Interpretive risk is the risk that their interpretation and application of the principles will not be approved by the regulator (Black 2008).
30 The extent to which financial services

institutions are compliant competent and adopt an ethical approach to their business is a strong indicator of senior managements commitment to compliance competence and corporate governance in general EDWARDS, J. & WOLFE, S. (2007) EthicalCompetence and Compliance Evaluation: a key element of sound corporate governance. ETHICAL AND COMPLIANCE-COMPETENCE EVALUATION, 15.
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4.4.2. Consumer Protection through Education and Public Awareness In order for consumer protection measures to be efficient, they must be accompanied by an appropriate level of consumer financial literacy and awareness (Wehinger, 2009). There is a need to develop a coherent and coordinated financial education strategy as a pillar of a sound financial regulatory and supervisory framework. Strengthening financial education and consumer protection31 will help to better equip individuals to deal with financial risks and responsibilities, and make them more resilient against adverse financial and economic shocks (Wehinger, 2009). In 2005, the FSA found out that consumers with higher levels of financial literacy are more likely to get a fair deal when saving or borrowing and will not be exposed to unnecessary levels of risk and other consequences of poor financial decision making32 (Gaskell and Ashton, 2008).

To illustrate the significance of consumer protection, the recent case involving the FSA fining JP Morgan Securities a record 33.32m for failing to protect its clients' money (by lumping it in with its own over a period of almost seven years), would have turned out worse had the firm become insolvent at any time during this period. The client would have suffered unexpected losses after trusting their wealth ($23bn) with the financial institution (BBC, 2010b). 31 Consumer protection can only be achieved with a high degree of competence and firms need to be committed to best practice. To do this effectively individual firms need to adopt the most appropriate method of training and competence required for their business to meet their T&C obligations EDWARDS, J. & WOLFE, S. (2005) Compliance: A review. Financial Regulation and Compliance,, 13, 4859.. 32 Credence goods are characterized by customers pre-eminent dependence on the expert knowledge and competence of the supplier. This imbalance of market power implies the exchange relationship is contingent upon the competence and integrity of the supplier. In retail financial services, the intangibility of financial services is further complicated as the consequences of decisions made today may not be known for many yearsDARBY, M. R. & KARNI, E. (1973) Free competition and the optimal amount of fraud. Law & Economics, 16, 67-88.

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4.4.3.

External Auditors Are Crucial

FSAs use of specialists such as external auditors makes up for the Bank of England's reduced presence in the supervision process33. External auditors have a greater role to play in bank regulation and supervision than was the case over 20 years ago34 as a result of globalisation. The difficulty of measuring and assessing risk within such institutions along with the speed with which assets can be adjusted in derivatives markets has led to more emphasis being placed on internal managerial control (Ojo, 2008). Further, the fact that almost unlimited powers have been conferred on FSA and that it is the all conquering body in relation to anything financial in the UK is critical.35 Given that FSA is both the judge and the jury raises concerns about its accountability, as it is a private company discharging public functions.36 (Omoyele, 2008).

33 External auditors have additional responsibilities in connection with financial services clients including reporting breaches of laws and regulations, and assisting the FSA as independent experts in their investigations. These externally-imposed compliance requirements should support and complement effective internal corporate governance structures SCHACHLER, M. H., JULEFF, L. & PATON, C. (2007) Corporate governance in the financial services sector CORPORATE GOVERNANCE 7, 623-634.. 34 A challenge that needs tackling is the fact that the UKs adoption of a risk based approach to supervision by its regulator, the FSA, has led to the reduction of the use of external auditors by the FSA OJO, M. (2009a) The External Auditor's Role in Bank Regulation and Supervision: A Comparative Analysis Between the UK, Germany, Italy and the US . 35The Financial Services & Markets 2000 Act creates the most powerful regulatory body for financial services anywhere in the world (Taylor, M. 2000). 36 For increased transparency and fairness, it may be advisable for FSA to be subjected to scrutiny not just by market players but by the wider public to ensure that proper regulation of markets is actually taking place. To ensure better stakeholder accountability, the industry should play a greater part in shaping its governance structure by electing the members of the FSA's board. The industry should be instrumental in choosing the composition of the board of the body charged with its regulation because the industry pays for its own regulation. Adopting this proposition would create more stakeholder accountability, as the FSA officials can be monitored by the public just like is done to members elected to parliament OMOYELE, O. (2008) CORPORATE GOERNANCE AS A CONTRAPTION OF THE FSAS ACCOUNTABILITY. Financial Crime, 15, 82-103..
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Perhaps auditors would have spotted the misreporting mortgage arrears data totalling 1,917 loans left out repossession figures since 2007 by two former Northern Rock directors if FSA relied on them more. If these omitted loans had been included, the number of borrowers in arrears would have increased by 50%.The FSA stressed that these figures were important to analysts and outside investors when judging the health of the company.37 This was particularly the case for Northern Rock as it relied on a positive market perception of its performance in order to fund its rapid expansion during a time in which it became the UK's fifth largest lender (BBC, 2010c).

The procedures performed by staff auditors are a critical component of the audit process, and mistakes in these procedures could jeopardize opinions if they are not communicated. While professional standards instruct auditors to report their errors, auditors have incentives to withhold information about mistakes because they are protective of their professional images. These conflicting pressures are examined by investigating the effects of mistake significance and superiors' historical reactions to mistake admissions on the likelihood that staff auditors will admit mistakes. We find an interaction suggesting that staff auditors are more likely to admit errors when their superiors have reacted positively, regardless of error significance. Conversely, staff auditors are less likely to admit apparently insignificant errors when their superiors have reacted negatively to prior mistakes (Stefaniak and Robertson 2010). This further stresses the significance of embracing ethics in business.

37 On the other hand it would be useful for the accountancy profession to consider ways of making financial reporting, especially on risk and auditing more useful to stakeholders ACCA (2009) The Future of Financial Regulation. The Association of Chartered Certified Accountants..

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4.4.4. Lessons from Islamic Finance The FSA has been showing a more receptive attitude towards Islamic banking. A number of financial institutions such as the Islamic Bank of Britain, the European Islamic Investment Bank, HSBC Amanah and Lloyds TSB offer Islamic banking and insurance products to Muslims in the UK. Furthermore, a significant number of Western financial institutions such as ABN AMRO, Citibank and Goldman Sachs have formed partnerships with Islamic players to promote Islamic banking in European and Western markets. The main players from both Islamic and conventional streams may pool their expertise and resources to devise more ethical and efficient solutions in business, investment and finance (Khan and Bhatti, 2008a).

What is attractive about Islam banking and finance system is that it offers more ethical and efficient alternative to the interest-based conventional financial system. Increasing numbers of Western financial institutions are using Islamic banking and finance as an opportunity to add innovation and diversity to their operations. The Islamic financial system facilitates lending, borrowing and investment functions on a risk-sharing basis. It also ensures the optimal rate of capital formulation and its efficient utilization leading to a sustainable economic growth and fair opportunities for all. It is a value-based system that primarily aims at ensuring moral and material wellbeing of the individual and society as a whole (Ahmed, 1994). This is primarily what is needed in the current financial services industry because as well as being consistent with the Wood (2002) framework for ethics based financial regulation, it fits well with the TCF initiative. Fairness and equity is the fundamental principle behind Islamic finance. Profits and losses are shared between lenders and borrowers. For instance, under an investment partnership mechanism known as musharaka a company that receives a loan will pay the hank through installments that include both the principal and a percentage of the company's profits. Under another venture capital system called

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muaraba, banks waive handling fees for company loans that fail to return a profit (OECD Observer 2009). Islamic banking replaces interest-based intermediation with profit and loss sharing (PLS) and interest-free intermediation. It does not subscribe to the conventional criteria of funding on the basis of borrowers' creditworthiness and strong collateral. Therefore, bad projects with strong collateral seeking bank credit cannot substitute for good projects (Khan and Bhatti, 2008b).

The other key distinguishing trait of Islamic financial transactions is to have high degree of transparency and disclosure in preserving the rights and responsibilities of the parties to a contract. Islamic finance requires the Islamic financial institutions to undertake the appropriate due diligence on the viability of business proposals and to meet the requirement for transparency and disclosure. Market conduct disclosure and customer relationship management form the core of these principles. Addressing the information asymmetry between Islamic banking institutions and the depositors/investors is of vital Importance (Islamic Financial Services Board et al., 2010). Given that Islamic finance is not new to the FSA, it may be worthwhile to borrow some principles about the frameworks used to uphold ethical business practices in finance. With the innovation of financial products still to continue, is it possible to learn and maybe use the technicalities that are employed in coming up with ethically sound products and contracts. Just as all are welcome to open accounts in Islamic banks without necessarily being Muslims, the financial industry could certainly borrow a leaf from the good qualities of Islamic finance as it seeks to perfect ethical business practices. What would be the implication of the FSA mandating that all financial service providers have Islamic financial products, albeit modified and with different names, but with the same ethical principles? In the light of the credit crisis, investors are keen to hold their accounts with financially sound and stable institutions. With increased public awareness and education about the benefits of such ethical financial products, there is no doubt that consumers would switch to the better option. This would

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cause a ripple effect and would result in competition in terms of ethical behaviour in businesses, FSA would have a lighter task in ensuring its principles are followed and fairness and transparency would prevail.

5. CONCLUSION
As far as promoting fairness and transparency, the current principle based approach to regulation is still relevant although with some shortcomings including the communication challenge between the FSA and the regulated community that is caused by lack of clarity, the challenge of achieving the right balance between enforcing compliance and encouraging the change in corporate culture, and the risk of regulatory capture. Given that financial service professionals will not all walk around with the FSA rules in their pockets, the 11 principles provide a good guide to acceptable behaviour and as ethical behaviour develops, less regulation will be required. Jackman (2001) proposed that developing value systems to go beyond compliance standards implies development of professional standards of integrity, honesty, fairness and responsibility. He further assured that such virtues are infectious and peer pressure is a very powerful way of spreading positive, as well as negative, influences.

An ethical, responsible culture should be a win-win for financial services firms. A firm that adopts and embeds a belief in the values that lie behind the FSA's principles is more likely to face fewer complaints and claims by consumers, be less prone to regulatory action, and see direct benefits enhancing its reputation and market share. The industry as a whole would also benefit from improved consumer confidence and a recognition of the professionalism and integrity of the industry (Davies, 2001).

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6. APPENDIX

Figure 1 Cooperative model of cultural organisational ethics (Wood and Rentschler 2003)

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OJO, M. (2008) The role of the external auditor in bank regulation and supervision: A comparative analysis. MPRA. OJO, M. (2009a) The External Auditor's Role in Bank Regulation and Supervision: A Comparative Analysis Between the UK, Germany, Italy and the US OJO, M. (2009b) The Financial Services Authority: A Model of Improved Accountability? . Center For European Law and Politics. OMOYELE, O. (2008) CORPORATE GOERNANCE AS A CONTRAPTION OF THE FSAS ACCOUNTABILITY. Financial Crime, 15, 82-103. SALMON, J. (2005) ABI onslaught at FSA enforcement tactics., Money Marketing. SCHACHLER, M. H., JULEFF, L. & PATON, C. (2007) Corporate governance in the financial services sector CORPORATE GOVERNANCE 7, 623-634. SCHEIN, E.H. (1985), Organisational Cultures and Leadership: A Dynamic View, Jossey-Bass, San Francisco, CA. STEFANIAK, C. & ROBERTSON, J. (2010) When Auditors Err: How Mistake Significance and Superiors' Historical Reactions Influence Auditors' Likelihood to Admit a Mistake. International Journal of Auditing, 14, 41-55. STEWART, S. (2005) Coping with the FSA's risk based approach. Financial Regulation and Compliance, 13, 43-7. SVENSSON, G. and WOOD, G.:2008, A Model of Business Ethics_,Journal of Business Ethics (2008) 77:303322 TAYLOR, M. (2000) Accountability and objectives of the FSA, London, Blackstone Press. THE FINANCIAL SERVICES PRACTITIONER PANEL (2006/7) THE FINANCIAL SERVICES PRACTIIONER PANEL ANNUAL REPORT 2006/7. TURNER, C. (2008) FSA rules out 'naming and shaming' practice., Marketing Week. THE OBSERVER (2010) Fresh political battle looms over Equitable policyholders. The Guardian. London. WEHINGER, G. (2009) The Turmoil and the Financial Industry: Developments and Policy Responses. IN OECD (Ed.) Financial Market Trends, Pre-publication version for Vol. 2009/1. OECD. WOOD, G. (2002), A partnership model of corporate ethics, Journal of Business Ethics, Vol. 40 No. 1, pp. 61-73

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