The current recession has brought about significant changes in the UK financial services sector, ranging from a hardening of the public’s attitude towards financial institutions to the partial nationalisation of two of the largest banks in the world (at a cost of billions of pounds). The UK’s first coalition government for 70 years is making its mark on financial services regulation by proposing radical reforms to the current regulatory structure. This article summarises the proposed reforms, the reasons behind them and their likely effect.
Perceived shortfalls of the current system
The UK currently has a tripartite financial regulatory system in which three authorities – the Bank of England (BE); the Financial Services Authority (FSA) and HM Treasury (the Treasury) – are collectively responsible for financial stability. A memorandum of understanding describes the role of each organisation, and the joint framework under which they assess, co-ordinate and respond to financial stability risks in the UK.
The government outlined its view of the failures of the existing system in a Treasury consultation paper entitled, ‘A new approach to financial regulation: judgement, focus and stability’ (the consultation paper), published on 26 July 2010. The government regards the overriding failure of the current system as being that no single institution has the responsibility, authority or powers to:
- monitor the financial system as a whole;
- identify potentially destabilising trends;
- assess the risks inherent in complicated financial products; and
- respond with concerted stabilising action.
In respect of the financial crisis leading up to the recession, the government considers that the tripartite system failed to:
- identify or mitigate the problems that were building up in the financial system, before they led to significant instability in financial markets;
- deal with the crisis adequately when it occurred; and
- provide clear and decisive leadership.
These failures were exacerbated by the following systemic weaknesses:
- a single monolithic financial regulator, the FSA, is responsible for all financial regulation, encompassing both prudential regulation, and oversight of consumer protection and market conduct;
- the BE has responsibility for financial stability, but does not have the tools to carry out the role effectively; and
- the Treasury has responsibility for maintaining the overall legal and institutional framework, but no clear responsibility for dealing with a crisis.
In the Queen’s Speech on 25 May 2010, the government announced that it intended to publish a Financial Services Regulation Bill reforming the regulatory framework. Specifically, the government intends to transfer the control of macroprudential regulation and oversight of microprudential regulation from the FSA to the BE.
The reason for this fundamental change is the government’s belief that only central banks have the required authority, knowledge and understanding of macroeconomics and markets to make macroprudential judgements. The financial crisis also demonstrated that central banks’ position as lenders of last resort requires familiarity with every aspect of the institutions that they may need to support.
George Osborne, the Chancellor of the Exchequer, went further when he announced in his Mansion House speech on 16 June 2010 that the government not only intended to abolish the tripartite system, but that the FSA would cease to exist in its current form. Further details have been provided in the consultation paper. In summary, the government intends to establish the following bodies to undertake functions currently performed by the FSA:
- the Financial Policy Committee (FPC);
- the Prudential Regulation Authority (PRA);
- the Consumer Protection and Markets Authority (CPMA); and
- the Serious Economic Crime Agency (SECA).
A broad outline of the composition and powers of each of these bodies is set out below. The finer details have yet to be established.
The FPC will be established as a committee of the BE Court of Directors, its governing body, and will be responsible for macroprudential regulation, which includes considering macro issues that affect economic and financial stability. It will have the power to address the risks it identifies, including to require the PRA to implement its decisions by taking regulatory action with respect to all firms.
The consultation paper describes the FPC as having a total membership of 11, comprising six members from the BE and five external members. Members will include: the BE governor as chairman; the BE deputy governor for monetary policy; the BE deputy governor for financial stability; a new BE deputy governor for prudential regulation (current FSA chief executive Hector Sants); two further BE executives; and the CPMA chairperson. In addition, the Treasury will have a non-voting representative on the FPC.
There will be close co-operation between the FPC, the PRA and the CPMA to ensure that the FPC is kept fully informed of any developments that might affect financial stability.
The FPC will be accountable to the BE Court of Directors, which will have responsibility for reviewing FPC procedures. The FPC will also be directly accountable to Parliament, as it will be required to publish biannual financial stability reports, and its decisions and deliberations will be scrutinised by the Treasury Select Committee.
The government will legislate to create the FPC, but intends to establish an interim FPC in autumn 2010 in advance of any legislation.
The PRA will be a legally distinct subsidiary of the BE. It will be responsible for the microprudential regulation of financial institutions, including retail and investment banks, building societies and insurance companies.
The consultation paper outlines the government’s goal that:
‘The legal framework for the PRA should underpin a more informed and judgemental approach to regulation.’
The government intends to consider whether any modification or alternatives to the Financial Services and Markets Act (FSMA) 2000 are required to accomplish this objective.
The PRA will have its own board, the majority of which will be non-executive members appointed by the Treasury. However, there will be some overlap between the PRA’s board and the CPMA and the FPC. The board will be chaired by the BE governor, and other members will include the new BE deputy governor for prudential regulation, the BE deputy governor for financial stability and the CPMA chief executive.
The PRA will be accountable to the BE Court of Directors. It is also envisaged that the PRA will be accountable to Parliament through mechanisms that the government is currently considering. For example, the PRA will be required to produce an annual report to be laid before Parliament.
The CPMA will take on the FSA’s responsibility for consumer protection and conduct regulation. It will therefore be responsible for the conduct of all firms, retail and wholesale in their dealings with ordinary retail consumers. The CPMA will be a strong consumer champion. Its primary objective will be promoting confidence in financial services and markets, and it is intended that it will take a tough, proactive approach to regulating conduct. The CPMA will inherit the FSA’s existing responsibility for the Financial Ombudsman Service, the Consumer Financial Education Body and the Financial Services Compensation Scheme.
The CPMA will be a company limited by guarantee and independent of the government. It will be controlled by a board with a majority of non-executives appointed by the Treasury. The PRA chief executive will sit on the board to assist in co-ordination and co-operation between the two bodies.
The consultation paper envisages that the legal framework for the CPMA’s powers and functions will be based on the model set out in the FSMA 2000:
‘With modifications to enable the new CPMA to carry out its conduct-focused responsibilities more effectively.’
The CPMA will be accountable to Parliament. It will be required to produce an annual report to be laid before Parliament.
In his Mansion House speech, George Osborne stated that:
‘We take white-collar crime as seriously as other crime, and we are determined to simplify the confusing and overlapping responsibilities in this area in order to improve detection and enforcement.’
The government proposes that the SECA will take over the work of the FSA, the Serious Fraud Office and the Office of Fair Trading in tackling serious economic crime. The SECA is not considered in the consultation paper as the government intends to undertake a separate consultation process for it.
Effect of the reforms
The proposed reforms are far-reaching. Inevitably, they will cause disruption and uncertainty to the regulated sector, those responsible for regulating it and the general public. Measures have been put in place to minimise disruption, including the following:
- The government is committed to implementing the necessary primary legislation within two years.
- The FSA will remain the UK financial services regulator until the legislation has been implemented and several senior FSA personnel will remain to assist with the transition, including Hector Sants and FSA chairman Lord Turner.
- The government has stated that it will be guided by four principles during the transition period:
- minimising uncertainty and transitional costs for firms;
- maintaining high-quality, focused regulation;
- balancing swift implementation with proper scrutiny and consultation; and
- providing as much clarity and certainty as possible for FSA and BE staff.
- The FSA has emphasised that firms regulated by it should assume that existing FSA initiatives will continue until its abolition in 2012, and beyond into the new regulatory structure, and that firms should continue to interact with the FSA as normal.
The financial crisis has given the government good reason to review financial services regulation and the proposed reforms are structurally radical. They are likely to cause upheaval and uncertainty at a time when (some might say that) the financial sector and the general public require confidence, certainty and strong representation. The consultation process will close on 18 October 2010 and many will eagerly await the outcome.