Legal Briefing

FSA CEO outlines new regulatory approach

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Finance | 01 February 2011

In a speech on 13 December, Financial Services Authority (FSA) chief executive Hector Sants outlined what firms can expect of the supervisory approach under the new regulatory structure following the abolition of the FSA in 2012. Sants attributed the financial crisis ‘first and foremost to massive misjudgements’ made by key financial institutions, before going on to accept that regulators (chiefly, one would assume, the FSA) also ‘share the responsibility for failing to limit the impact of these misjudgements’. In answer to these failings, Sants outlined the improvements that are needed to be made to the firm-specific rules and regulators’ supervisory practices.


As has been well reported, the FSA’s current wide remit will be split between two new regulators. The Prudential Regulatory Authority (PRA), which Sants is set to head up, will be a focused prudential regulator with the single objective of promoting the stable and prudent operation of the financial system. It is to achieve this by regulating large and key financial institutions to minimise the disruption caused if they fail. A new body, the Financial Policy Committee, will provide the macro-prudential framework that the PRA will use when assessing individual firms. The second new regulator will be the Consumer Protection and Markets Authority (CPMA), which will have the remit of conduct of business supervision for firms and the market in general. The head of this new regulator has yet to have been designated, but its primary focus will be on protecting consumers and ensuring market integrity, with a view to maintaining confidence in the financial system. Sants’s speech therefore provided an insight into how the two regulators will set about achieving their objectives with regard to the supervision of financial services firms.

PRA

Regarding the PRA, Sants pointed out that its objective is not ‘zero-failure’, ie that no institution should fail on its watch, but is moreover to ensure that if and when there are failures, that they should cause minimal disruption and avoid cost to the economy, and, more importantly, to the taxpayer or individual customers. This will drive its approach to the supervision of firms it will regulate from a prudential perspective, such as banks, building societies and insurers. The PRA, unlike the FSA, will spend more of its resources on reducing the effect of firms failing than on the probability of doing so.

To this end, the PRA’s approach to an individual firm will be based on whether it is assessed to be a low, medium or high-impact firm, using the PRA’s new risk model, based on judgements related to inter alia, gross impact of failure, systems, controls and culture, liquidity, and resolution planning. Low-impact firms, unsurprisingly, receive relatively little attention from the PRA, with supervision centring on ‘resolvability, on monitoring compliance with rules and reacting to an issues that might arise’, similar to the approach currently adopted by the FSA in respect of smaller insurers and credit unions. While at the other end of the spectrum, high-impact firms can expect to be the focus of a large amount of PRA resources, in the form of ‘intensive, intrusive, judgement-based supervision’ to scrutinise issues that affect the ‘safety and soundness’ of the firm.

Sants’s goal for PRA supervision is to introduce a formal, proactive intervention framework to ensure that concerns about individual firms are identified and remedied at an early stage. The stated dual purpose of this framework suggests that Sants sees a division of responsibility between the firm and the regulator, in that it requires a firm to take remedial action to reduce the probability of failure, while alerting the authorities of the need for action to deliver failure or resolution of the firm in an orderly manner, therefore minimising disruption and cost. It will be interesting to see whether such a division manifests, given the current focus of the FSA on assessing the appropriateness and strength of orderly wind-down plans and ‘living wills’.

The decision to make interventions by the PRA will be based on concerns arising from similar data to those that the FSA use, ie from business model and market analysis, engagement with auditors and the regulator’s own in-depth stress testing, but intervention will occur earlier and in a more graduated way than at present. The PRA will have its own enforcement powers (though likely to be much more limited than its new sister regulator, the CPMA – see below), which Sants says it will not hesitate to use.

Commenting on the approach of the regulatory he will head up, Sants confirmed, ‘in many respects, the regulatory philosophy of the PRA is an evolution of the current approach taken by the FSA’. In the speech, Sants adopted (on behalf of the PRA) the FSA’s buzzword ‘outcome-focused’, and said that the PRA will continue the more recently developed approaches of intrusive supervision and making judgments on firms’ management decisions. Whether or not this approach is welcomed, they are ideas that the FSA has developed and implemented in response to the financial crisis and related criticism, firms will at least be familiar with this supervisory approach under the new regime. The differences to which firms must become acclimatised lie more in the focus on orderly resolution, on adherence to the purpose and the substance of the rules (from firms’ management and regulator alike), and the clearer links between systemic stability and the effective regulation of individual firms.

CPMA

In contrast to the PRA, the CPMA chief executive designate has yet to have been announced and this leaves a significant part of the thinking behind its supervisory approach undiscovered. Sants’s speech, however, provided a fairly reliable prediction of what firms can expect of the new conduct of business regulator. In contrast to the PRA’s narrow focus and small number of regulated firms (2,200), the CPMA’s objectives and scope are wide-reaching. Although there will be a primary focus on the protection of consumers, the CPMA’s remit includes the conduct of both wholesale and retail firms (an approximate total of 25,000 firms), and the efficiency and integrity of the market itself, including the UK Listing Authority.

With regard to the label of ‘consumer champion’ that the CPMA has been given, Sants’s view is that this will inform its supervision approach to a degree, stepping in on consumer protection grounds:

‘As soon as potential concerns begin to emerge and having a willingness to take greater risk of being overturned on appeal if it thinks that early intervention is warranted.’

Firms may receive some comfort from Sants’s statement that this does not mean that the CPMA will operate on the basis that the customer is always right or that ‘consumers have no responsibility to look after their own interests when dealing with financial services firms’. It can only be assumed, however, that such a clear consumer remit will lead to an expansion and augmentation of the FSA’s ‘treating customers fairly’ regime. Furthermore, to achieve this objective, Sants advocated that the CPMA be given greater powers of intervention and disclosure than those that the FSA currently has, though did not elaborate on what these might be.

Somewhat similarly to the PRA, the CPMA will use its chosen risk model (likely to be at least based on the FSA’s current ARROW model for assessing and dealing with risk) to achieve earlier risk identification and, where needed, earlier intervention. Sants candidly stated that the FSA’s historic strategy of ‘focusing on high-level systems and controls and information disclosure to consumers has not proved effective’, leading to an unacceptable level of consumer detriment for which the CPMA must adopt a lower risk tolerance than that of the FSA. It must also, in Sants’s view, focus supervisory resources towards more thematic industry-wide interventions, although not at the expense of an all-inclusive programme of firm visits as currently operated under ARROW. However, how that would work in practical terms is not a logistical dilemma that Sants has to work out. He did, though, offer the suggestion that the CPMA’s resources should be deployed in a such a way as to flexibly tackle issues and risks.

According to Sants, another area where improvements are needed and should be delivered by the CPMA is how conduct issues within wholesale firms are addressed, which he said ‘have been somewhat overshadowed by [the FSA’s] focus on market abuse’. The FSA Handbook is relatively light on provisions related to standards of conduct for wholesale firms, where investment banks and large, experienced investors are deemed to be capable of protecting their own interests, and appropriate standards are perceived to be delivered by principles and market discipline. However, in Sants’s view at least, this is going to change significantly, not just in terms of a supervisory approach, where the CPMA should be willing to intervene earlier in wholesale conduct issues (especially where these could have a knock-on affect on consumers), but also in terms of additional regulatory requirements for wholesale market participants. This would mark a significant shift in the operating model and focus of the wholesale conduct regulator, and is a reflection of the close link of wholesale and retail markets as one of the perceived root causes of the financial crisis.

In an interesting policy u-turn, Sants’s speech signalled a move away from the current principles-based approach that the FSA has adopted for the past three to four years and heralded a return to more prescriptive rules:

‘Work is already underway to identify those risks where the prescription that rules provide is the most effective way to protect consumers.’

The ultimate regulatory landscape will no doubt be, as it is now, a mixture of both principles and rules, but it is clear that a switch of emphasis is on the horizon.

In another u-turn, this time by the government, after some debate and serious lobbying against removal in favour of a new economic crime agency, HM Treasury has announced that the CPMA is to inherit the FSA’s current powers to carry out criminal investigations and prosecute for insider dealing. This will help lend weight to the regulator’s enforcement arm and allow it to continue the current successful ‘credible deterrence’ strategy, which it has been building since 2007, something with which Sants appeared to concur:

‘It is vitally important that the willingness to take strong and effective enforcement action is central to the CPMA’s philosophy.’

CO-ORDINATION

While some might say that the FSA is not always an internally consistent and well co-ordinated organisation, clearly separating out its functions between two different regulators can only lead to the potential for increased regulatory burden for firms, and conflicting standards and approaches. For the most part, the two supervisory regimes outlined in Sants’s speech do seem to be complementary in nature, with a focus on early intervention, intrusive supervision, a continuation of credible deterrence and a risk-based approach. This is perhaps entirely to be expected in the theory of the chief executive of the present regulator, who is also to be the head of one of the new regulators. However, it is of major concern for all within the industry as to how the potential for inconsistencies, duplication and increased unnecessary bureaucracy will be dealt with between the PRA and the CPMA in practice. On this point, Sants provided some fairly bland promises about a high-level memorandum of understanding, domestic colleges for joint working on the supervision of firms and cross representation on policy boards. We will have to wait for the new regime’s commencement in 2012 to see whether these steps can provide the comfort for firms that Sants envisages.