The new UK coalition government announced that it will introduce legislation to disband the UK financial regulator, the Financial Services Authority (FSA), which was established by the previous government in 1997. Legislation will devolve the FSA’s regulatory and supervisory powers to a variety of other financial regulatory supervisory bodies by 2012. Bob McDowall of TowerGroup reviews the impact of the prospective changes on financial services institutions.
The New Structure: The Pieces Have Been Rearranged and Others Added
At the heart of the UK’s new regulatory and supervisory structure are the “twin peaks” of regulation: the Prudential Regulatory Authority, which will oversee the financial strength and safety of all financial institutions, and the Consumer Protection and Markets Authority, which will regulate retail and wholesale markets. The reforms cover not just the FSA but also a number of other agencies. For example, the Economic Crimes Agency will combine the enforcement powers of the FSA with the powers of the Serious Fraud Office and Serious Organized Crimes Agency with a remit that extends beyond the financial services sector. The new structure applies to financial investment in the United Kingdom and firms conducting financial services within the UK jurisdiction. So the wholesale financial markets will come under the new regulatory regime as long as they operate in the United Kingdom, even though they are international in scope,
Key Challenges
Calibrating Prudential Supervisory Response
The Bank of England’s major challenge will be to ensure that its Prudential Regulatory Authority arm and the separate Consumer Protection and Markets Authority calibrate their responses to the two policy-setting roles of the Bank of England: setting interest rates through the Monetary Policy Committee (MPC) and the macro-prudential regulation through the new Financial Policy Committee (FPC). Success will be judged over time based on financial services institutions’ (FSIs’) delivering and absorbing a steady supply of credit without any asset-pricing bubble such as those that burst in the past, resulting in FSI failures and heightening systemic risk.
Establishing Effective Coordination Between the “Twin Peaks”
In postmortem analyses of the financial crisis, internal regulatory inquiries and the UK Treasury Select Committee among others acknowledged that the tripartite coordination of the FSA, the Bank of England, and UK Treasury failed to anticipate the crisis or make a coordinated response to reduce its impact. Effective coordination between the Prudential Authority and the Consumer Protection and Markets Authority is an essential lesson that the new regulatory regime must learn from the financial crisis of 2007–09.
With the exception of periodic appearances before the UK Parliamentary Treasury Select Committee, there will be no formal regulatory oversight of the new regulatory structure. Therefore, the Prudential Authority and the Consumer Protection and Markets Authority must agree on (and set out in a detailed “memorandum of understanding”) how they will communicate their markets and risk intelligence and coordinate their responses to events that threaten the financial strength and safety of financial markets and FSIs. Regulators must take such measures to assure FSIs and investors that they have rectified the weaknesses of the “tripartite” agreement under the existing regulatory regime.
Formal Oversight of the New Regulatory Regime Seems Limited to the Treasury Select Committee
The lack of formal oversight, coupled with a concentration of power and reach, will pose some organizational challenges, even if just perceived, to adequate risk management. It should be remembered that even though the new structure is untested, the Bank of England had much greater powers in the past. One reason for the creation of the FSA was to try to ensure that events such as the bank failures and failings such as BCCI and Barings would not happen again. The structure may also need to be tweaked because it currently divides the world by regulatory function, whereas the majority of European proposals are pushing for reform along business lines.
Even Greater “Principles-Based” Emphasis of UK Financial Regulation Than Before
The Bank of England is likely to exacerbate regulatory tension at the European level by adoption of principles-based regulation in contrast to the rules-based approach of major national European financial regulators such as those of France and Germany. Regulatory tension will heighten further in light of the European Union’s political agenda to transfer key European regulation for banking, financial markets, and insurance to three new bodies commencing in 2011. Yet, the UK government, other national and supranational regulators, FSIs, and investors will judge the Bank of England by the successful conduct of macro-prudential regulation through the FPC and the safety of FSIs through the financial system’s Prudential Regulatory Authority. The Bank of England will be able to discharge these function only through a principles-based approach to financial regulation rather than a prescriptive, rules-based approach.
Cultural Changes: Fewer Poachers Turned Game Keepers and Game Keepers Turned Poachers
The new regulatory regime is likely to return to the culture that prevailed when the Bank of England was responsible for financial market supervision prior to 2000. The Governor of the Bank of England is now on record stating that he will be looking for career regulators, not people who think their careers may be advanced by spending three to five years working for a financial regulator before returning to more senior positions and remuneration at a financial institution.
Will the Costs of Financial Regulation Diminish?
Neither the UK government nor the Bank of England has given any indication of the financial budget for operating the new regulatory structure. The industry should anticipate a reduction in the overall cost of its regulatory subscription costs in line with the UK government’s cost cutting and streamlining of the public sector. The 2010–11 budget for financial regulation in the UK is £458 million. Regulatory fines, which currently exceed £50 million for 2010–11, are reinvested in financial regulation to reduce the operating cost of the regulatory structure (in contrast to most jurisdictions, where fines go into central treasury funds). Reinvestment of fines in the financial regulatory structure to reduce regulatory subscription costs may cease under the new structure. The Economic Crimes Agency will combine the enforcement powers of the FSA with the powers of the Serious Fraud Office and Serious Organized Crimes Agency with a remit that extends beyond the financial services sector, so reinvesting regulatory fines becomes a more complicated financial exercise.
Conclusions
The UK government has, superficially at least, rearranged the components of the financial regulatory structure but has placed responsibility for them with the institutions that can make them work most effectively. For example, the functions of the Prudential Regulatory Authority, which will oversee the financial strength and safety of all financial institutions, are key responsibilities of the Bank of England. Reduction in job hopping between financial institutions and the financial regulators should maintain some control over regulatory salary increases. The major uncertainty remains the level of regulatory costs.
This article is based on research by the European service at TowerGroup, a leading research and advisory services firm focused exclusively on the global financial services industry. Research Director Bob McDowall can be reached at bmcdowall@towergroup.com. Those interested in learning more about TowerGroup or subscribing to its research services may call +1.781.292.5200 or e-mail bmcdowall@towergoup.com.
