Outlook: Howard's end leaves a decent legacy for McCarthy to build on

After six years at the helm, Sir Howard Davies yesterday bowed out as chairman of the Financial Services Authority, the all powerful City regulator. Let's hope that nothing seismic happens over the weekend for, technically, his successor Callum McCarthy, doesn't start until Monday.

Financial regulation is a thankless task. Taken for granted if things are fine, regulators will invariably get it in the neck when things go wrong. On the one hand, they are accused of tying up the industry in costly red tape, on the other of being asleep at the wheel when scandal erupts. There's always too much or too little regulation, never just enough.

So how well has Sir Howard managed to navigate his way through this minefield of public expectation, and what's the prognosis for his successors, with the top job now shared between Mr McCarthy as chairman and John Tiner as chief executive?

The FSA is an experiment in financial regulation which has largely worked. It won't be the reform that Gordon Brown, the Chancellor, is most remembered for, but he still counts it among his biggest successes. The FSA found its origins in the decision to create an independent Bank of England in the first days of the Labour government. Up until that time, the Bank had been responsible for banking supervision.

Rightly, Mr Brown took the view that the Bank could not be trusted as an independent monetary authority as long as there was a danger of its credibility being undermined by some ghastly regulatory cock-up. The three preceding banking collapses - Johnson Matthey, BCCI and Barings - had all in part been down to regulatory failure, so the Bank's credibility as a supervisor was already badly dented.

There was also a desperate need, after some high profile mis-selling scandals, for regulation of the retail financial services industry to be strengthened and modernised. All this coincided with the explosive growth of wholesale financial markets in the City, where securities regulation fairly obviously needed to be redrawn. Whether it was right to bring all these different elements together under one all powerful super regulator is still open to debate, but there is no doubt that the formation of the FSA, for which operationally Sir Howard was responsible, was flawlessly executed.

In the early years of the FSA, Sir Howard could do no wrong. He was flavour of the month, and the FSA was widely thought a triumph which other financial centres around the world would want to emulate. Far from undermining the City's success as a financial centre, as some commentators predicted it would, the FSA seemed only to buttress it. Some American investment bankers liked the new regulator so much that they switched business from New York to London and consolidated all their European operations into the City.

Happy days. Like most stays in high office, Sir Howard's has proved a game of two halves. Disillusionment was quick to arrive as the boom, when any old fool could make money, turned finally to bust, when losing it proved even easier. In no particular order, Sir Howard has been blamed for the collapse of Equitable Life, the wider meltdown in the insurance industry, the split-capital investment trusts scandal, endowment mis-selling and, perhaps most cutting of all, an all consuming tidal wave of red tape and directives that risk undermining the City's position as the world's leading international financial centre.

In fact, very few of these charges bear any serious scrutiny. All but the last are in any case largely a function of the bear market, which given that it has been one of the worst in living memory, has actually been remarkably benign in its effect. Many more scandals and collapses might have been expected. In the event, there hasn't been a single banking collapse and even the insurance and savings market has largely steered clear of full scale insolvencies.

Life funds representing roughly a quarter of all with-profits money have been forced to close to new business, which is a bad enough result, condemning policyholders to years of poor returns and taking them out of the equity based products they signed up to. Yet no one has been unable to honour their liabilities. Some serious flaws in the system have been exposed but, in a Heath Robinson sort of way, it has also worked.

Of course, nobody can say whether things would have been any different had the FSA not existed. That's the other problem with attempting to assess the effectiveness of regulation. You only get to hear about the disasters, never the successes. The fact that there have been so few insolvencies might be taken as indicative of success, yet the truth is that there have been few failures anywhere, never mind whether the FSA was responsible for oversight.

The City largely escaped the scandal of tainted research that engulfed Wall Street, but again that may have less to do with the FSA's powers of prevention and a lot more to do with the fact that the FSA chose not to make an issue out of it. In truth, the amount of pulp research produced in the City at the height of the boom was just as great as on Wall Street.

In the aftermath of the bubble, the FSA has focused more on the causes of puff research than past miscreants. The fund management industry would like to think the issue of soft commission, under which they pay for research and information services through dealing commissions then on charged to their clients, has been kicked into the long grass. In fact the FSA is close to announcing a root and branch crackdown.

In the round, then, the Davies legacy is a good one. The regulatory burden on the financial services industry has grown enormously, but then in certain areas, particularly retail financial services, where mis-selling, poor record keeping and excessive charging were rife, it needed to.

As for the City's wholesale markets, there has been disturbing evidence over the past year or two of the weight of regulation reaching a tipping point, where it becomes more of a deterrent to participants than an attraction. Technology has made capital, and the people who control it, highly mobile. They don't have to work in the City, where lightness of regulatory touch has long been a key ingredient of success.

Mindful of these concerns, John Tiner, the new chief executive, promises swifter and less complicated regulation, a veritable bonfire of red tape. However, despite everyone's good intentions, the bonfire keeps growing, and somehow it never seems to go up in flames. It will be up to the new chairman, Callum McCarthy, to ensure the match is indeed struck.

The omens seem good. Mr McCarthy is a former City man himself, with a strong belief in the idea that markets should be set free. Beyond acceptable powers of oversight, he doesn't believe in government interference. Conscious of the prohibitive costs of a zero-failure regime, he's certain to continue with Sir Howard's risk-based approach to regulation. Markets need the occasional failure in order to make investors cognisant of risk and thereby ensure that capital isn't misallocated. As Sir Howard has found, getting that message across to the public is not always easy. If an organisation has the FSA's stamp of approval, savers expect it to be bullet proof, and are prone to demand compensation when it is not.

It is therefore essential that Mr McCarthy halts the progressive creep of compensation culture. Mortgage endowment compensation has become a scandal greater than the mis-selling phenomenon it is meant to address. Poor record keeping has laid the insurance industry open to a flood of unjustified claims, the effect of which is severely to damage the interests of policyholders who accept the risk they signed up to.

Effective regulation is all about getting the balance right. The good news is that Mr McCarthy knows that better than any.