Moving the deckchairs? UK regulation in flux again (Part 1)

The British Chancellor of the Exchequer, George Osborne, announced in the House of Commons on 16th June that the Financial Services Authority will be eradicated and the Bank of England will be given responsibility for both macro- and micro-prudential financial services regulation in 2012.

Further detail was given in his Mansion House speech that evening, and embellished by the Governor of the Bank of England, Mervyn King, in his speech at the same event.

None of this is a complete surprise, given the clear statement in the Conservative election manifesto:

"We will make the Bank of England responsible for macro-prudential regulation, judging and controlling risks to the financial system as a whole. We will create a powerful new Financial Policy Committee within the Bank, working alongside the Monetary Policy Committee, which will monitor systemic risks, operate new macro-prudential regulatory tools and execute the special resolution regime for failing banks. The failed Financial Services Authority will be abolished" [from the Latin ‘abolere’, to destroy, expunge from the record].

Mr Osborne is also rushing to implement a banking transaction tax before there is any sign of international agreement on the matter - which is up for consideration by G20 in November.

Finally, he is to set up a Commission to examine whether deposit-taking and investment banking activities should be structurally and legally separated – an equivalent to the proposed Volcker Rule in the US, sponsored by President Obama, which also finally appears to have developed a significant head of steam.

Proposed structures

• Within the Bank of England, a Financial Policy Committee will be created – presumably a peer of the existing Monetary Policy Committee – to identify and act on threats to macro-economic stability.
• A new micro-prudential regulator will be formed as a subsidiary of the Bank of England, with (no longer) departing FSA Chief Executive Hector Sants as its first Chief Executive.
• A new conduct regulator, the Consumer Protection and Markets Authority, will be formed, covering every aspect of retail and wholesale financial services conduct.
• Finally, the creation of a unified serious economic crime agency, presumably merging the Serious Organised Crime Agency and the Serious Fraud Office, and re-absorbing the prosecutorial authority currently enjoyed by the FSA.

Outline

Let us be clear – this is largely a political construct. Aside from the change of Government, those in charge at the onset of the current crisis – Mervyn King at the Bank and Hector Sants at the FSA – remain in charge of the new system, supported largely by the same staff in different boxes.

Proposed approach

There are very clear indicators as to the new regulatory and supervisory approach contained in the speeches:

• Ensuring less box-ticking and more exercise of judgment, reversing the seemingly inexorable trend towards more regulation and more regulators
• Avoidance of an overly legalistic culture with its associated compliance-driven style of regulation
• The exercise of discretion in setting fixed capital and liquidity ratios for individual banks
• The FPC’s macro-prudential overview feeding directly into micro-prudential decisions and actions taken by the new regulator

Reflections of History

The financial services regulatory structure in the UK has always been prone to change, and there is a distinct back-to-the future feel about the Chancellor’s proposals. Until 1998, banks and the money markets were regulated by the Bank of England. The Conservative government passed the Financial Services Act in 1986 to provide for the regulation of investments and of investment-based insurance, of securities and markets, creating the Securities & Investments Board (SIB), which in turn recognised a number of Self-Regulatory Organisations and delegated supervisory powers to them. The SIB’s oversight also extended in delegated form to the investment businesses of banks.

In practice this was not so much the ‘twin peaks’ model as currently envisaged, but more of a small mountain range populated by an alphabet soup of regulators such as the widely-respected Securities & Futures Authority.

Following the change of government in 1997, banking supervision and the associated staff transferred to the SIB (renamed as the Financial Services Authority) in 1998, as the Bank of England was given independence from government and key responsibility for monetary policy. The nine predecessor regulatory organisations also had their staff transferred to FSA and leased back in 1998.

The restructuring was principally a result of the multiplicity of overlaps and rulebooks, lack of consistency and patchy effectiveness, and thinly disguised turf wars under the Financial Services Act structure, but also, in part, to perceived supervisory failures by the Bank of England as regulator in relation both to the Bank of Credit and Commerce International in 1991 and of Barings Bank in 1994.

In terms of powers, as of now FSA already has powers to set individual capital requirements as a response to perceived poorly-controlled risk. It has powers to discipline, fine and ban individual bank directors and other senior managers for demonstrable failures to discharge their responsibilities. We are left asking what, if anything, will change beyond the organisational structure of regulation? The existing structure would suffice with minimal modification, buttressed by clear public policy instruction from the incoming government.

However, the change has been announced, so what are the implications?

Practicalities of the proposed arrangements

Broad issues

• Regulation and supervision is an activity carried out by people, and its quality is dependent upon their competence and abilities. On the basis that you can not create new supervisors overnight, most of the FSA staff – both the able and the less able - will transfer to one of the new organisations and carry on their existing roles


• The internal timescale laid out by the Chancellor – a maximum of 18 months – is hugely challenging, given that primary legislation needs to be drafted, consulted on ‘widely’, debated and amended in both Houses of Parliament, passed into law, FSA staff shared out (with all the employment law paraphernalia that goes with that), and the FSA Handbook split and redrafted


• The new structure will be dependent on effective ‘College of Supervisors’ arrangements between the new regulators. Both at EU and domestic level, the history of such arrangements is one of absolutely minimal success


• Alignment and representation in existing and new European regulatory forums, at an absolutely critical time for the shaping of future European regulation. Clearly the new FPC will align with the European Systemic Risk Board, and the new Prudential Authority with the European Banking Authority: presumably the new Consumer/Market regulator will align with the European Securities and Markets Authority. Who will represent the interests of the UK on the absolutely critical European Supervisory Authority, and on the insurance and pensions regulator?

Transitional issues

• Where senior management of the FSA and the Bank of England are focused on structural change to an incredibly tight deadline, who leads in Europe? The game-changing Alternative Investment Fund Management Directive and the detailed review of MiFID and the Market Abuse Directive are happening now, and have potentially serious implications for London’s position as Europe’s financial centre.


• FSA Enforcement activity, both in terms of investigations and disciplinary actions, is at an all-time high. The timescales between initiating an FSA investigation and matters reaching Tribunal, settlement or prosecution, are typically measured in periods exceeding 18 months. This must raise questions as to:
  • FSA’s willingness to initiate new investigations during the interregnum;
  • the ability for defendants to benefit from structural confusion;
  • the powers, practices and targets for enforcement within the new regime
  
  
• FSA in pursuit of effective regulation and credible deterrence has materially increased staff numbers and the amounts that they are paid: by comparison, existing Bank of England staff are underpaid. This is potentially seriously disruptive, as it implies:
  • persuading existing Bank of England staff to accept the imbalance,
  • persuading existing FSA staff to accept a pay cut, or
  • bringing existing Bank of England staff up to comparable pay levels.
  
  
• Morale and motivation – FSA staff have suffered since the manifesto pledge was first published from uncertainty and low morale. Now that they know the axe will fall, then for the next eighteen months focus will inevitably be split between pursuing current regulatory priorities and their own futures – potentially seriously weakening regulation at a time when a second leg to the financial services crisis, centred around the weaker Eurozone countries, remains a very real possibility.

Conclusion

It is even more important for banks and financial services companies in this new climate to remain vigilant and to focus clearly on managing their own risk profiles.

In the next Chase Cooper newsletter we will focus on the implications and priorities for individual firms arising from these fundamental changes, as well as looking at the European implications and the conflicts of interest arising for the Central Bank.

Nick Gibson, Editor
nick.gibson@chasecooper.com