UK: UK’s New Regulatory Approach Emerges

Last Updated: 27 November 2012

The long anticipated FSA split into the PRA and FCA is likely to take place in April 2013. To prepare the market, the BoE published twin papers outlining The PRA's approach to banking supervision and The PRA's approach to insurance supervision in October. These papers, along with the FSA's publication Journey to the FCA, shed more light on the new UK framework for prudential and conduct regulation.

Firms should consider these papers carefully - they offer important indicators of how the new regulators will focus their resources. Understanding their approaches now will prove time well spent when the regulators take up their new powers next April.

Common themes

The new regulatory authorities share complimentary objectives and say that they will adopt a similar approach to regulation. Each regulator's objectives recognise the importance of financial stability in both retail and wholesale markets. They will both be very interested in firms' cultures and how their senior management teams are performing, but will come at these issues from different perspectives.

Both regulators intend to be more intrusive and forward-looking than the FSA. They will focus not just on the rules, but also on firms' cultures, the attitude of senior management and the viability of the business. The PRA and the FCA both plan to have frequent contact with firms that are deemed to present a high level of risk – either to the regulators' in meeting their objectives, the stability of the financial system or to the interests of consumers.

The new approach relies the exercise of more judgement by regulators, which means they will need staff who have the experience to form judgements and the confidence to stand by their decisions.

The new approach will be more resource intensive for the regulators and for firms that pose significant risks. To manage their resources, both regulators intend to concentrate their efforts on supervising high risk firms, leaving lower risk firms with a less intrusive regime.

PRA supervisory approach

The PRA's approach to prudential supervision of banks and investment firms will be based on just one objective: promoting the safety and soundness of the firms it supervises. The PRA will not keep firms from failing but it will seek to ensure that if a firm fails, its customers will be appropriately protected ( e.g. via the FSCS), and that there will be minimal disruption to the supply of critical financial services. The PRA will also expect firms be resilient to the failure of other market participants.

The PRA has an additional objective in respect of insurers: to contribute to securing an appropriate degree of protection for those who are or may become policy holders. This objective will factor into the risk assessment of insurance firms and groups. Otherwise, they will apply the same supervisory approach to insurers.

Supervision

The PRA will divide its regulated firms into five prudential supervision categories (P1 to P5) based on risk profiles. The BoE estimates that around 20 firms will fall into the highest risk category - firms whose failure could cause "very significant disruption" to the financial system. One third of PRA supervisors will be devoted to this group. The BoE estimates that 70 to 80 firms will be captured by the next category – firms whose failure could prove individually disruptive. Those firms will be supervised by another third of PRA staff. The 1,500 or more firms which are not deemed individually significant, but for which together with other firms could cause widespread failure across a sector with serious consequences, will form a further three tiers. These lower risk firms will be supervised by remaining staff on a group basis.

Proactive intervention

If the PRA deems that a firm is at risk of failure, it has new powers to intervene. A five stage process will give the PRA increasing powers of intervention, including powers to remove authorisation for new businesses, limit trading activity and require a change in the firm's management, as the risk of failure escalates. The intervention process includes contingency resolution planning, in the event that PRA intervention is unable to prevent a firm from failing.

FCA supervisory approach

The FCA's broad objective is to ensure that financial services markets function well, and this is supported by three underlying operational objectives:

  • secure an appropriate degree of consumer protection
  • protect and enhance the integrity of the UK financial system
  • promote effective competition in the interest of consumers.

The BoE says that FCA will focus on supervising the corporate governance and market conduct of its regulated firms. It will intervene where it deems necessary to ban products that it believes are unfair or harmful to consumers, to ban misleading financial promotions and to pursue enforcement action more rigorously than in the past.

Under a new Business Model Threshold Condition, firms will be required to demonstrate that their business model is appropriate, viable and sustainable given the nature and scale of their business, and include some contingency planning. Firms must be able to demonstrate how their business model will enable them to effectively meet the needs of customers without placing them at undue risk or undermining financial stability. The FCA will be forming its opinion of the attitudes and suitability of senior management from the business model review.

Risk based supervision

As with the PRA, the FCA will divide firms into four conduct supervision categories (C1 to C4) based on the risk that the firm presents to the FCA's core objectives. The FCA will classify firms depending on the size of their retail business and/or the market impact of their wholesale business, with tetail business activities subject to closer supervision than wholesale business activities of a similar scale.

Firms that are designated C1 or C2 will have a nominated supervisor and be continuously supervised. The FSA will supervise firms in the C3 and C4 categories collectively by teams of sector specialists.

A new division called Policy, Risk and Research, to be staffed by 250 people, will monitor the market for developments that pose risks to consumers, markets and firms, to try to anticipate problems before they become significant. It will assess those risks to develop a common view, to inform the FCA's policy-making, supervision and enforcement activities.

Wholesale conduct

Although the FCA is bringing in a strong retail focus, wholesale firms will be subject to more scrutiny than before. The FCA believes that poor conduct originating in wholesale markets is regularly transmitted into the retail sector. Going forward, wholesale firms will need to be alive to which of their activities could affect consumers in the retail space.

The FCA also disagrees with the traditional view that all wholesale market participants are equal, and capable of looking after themselves and managing their relationships with other market participants effectively, with little regulator intervention. Wholesale firms should be taking a close look at their counterparties - they can no longer assume that smaller market participants necessarily have the skill or experience to understand all products.

Competition

The FCA will have a new objective to support competition, framed in ensuring retail customers have access to appropriate products at affordable prices. It is not clear yet how the FSA will achieve this. The FCA would particularly like firms' views on how it can encourage competition to benefit consumers, how it can monitor improvements in the competitive landscape, and what barriers firms face to entering the market or expanding their businesses.

Prudential regulation

The FCA will be directly responsible for prudential regulation of approximately 23,000 firms – consisting of all firms other than the deposit-takers, insurance companies and a few systemically significant investment firms which will be regulated by the PRA. The FCA will divide firms into three prudential categories (CP1 to CP3). CP1 will include those firms deemed prudentially critical. CP2 will include prudentially significant firms, and the remainder of prudentially insignificant will fall in CP3. Only CP1 firms and MiFID regulated CP2 firms will be subject to ICAAP and ILAA reviews. Other firms will have to ensure that they have adequate capital to enable an orderly wind-down in the event of failure.

The FCA may not be able to reduce the capital burden for smaller firms, as it is unable to exempt smaller firms from MiFID and the CRD requirements. In practice most firms are unlikely to see a significant change in capital requirements, but some may experience less prudential scrutiny.

Dual regulation

The PRA regulated firms will be subject to FCA conduct regulation. A draft memorandum of understanding between the two regulators, published in January 2012, establishes the scope of each of the PRA and FCA's duties.

The regulators will undertake supervisory activity together where possible, and will share information from their individual activities where necessary. The PRA lead on authorisation, variation of permission and approval of Approved Persons for dual-regulated firms, but the FCA has power of approval. The FCA will approve individuals for customer facing functions.

The regulators will maintain separate rulebooks and each will have the authority to grant waivers, but must notify the other before a waiver is granted. The PRA has the power to veto the actions of the FCA if it feels that the FCA's actions may threaten the stability of the financial system or induce the failure of a systemically important, dual-regulated firm.

Transition

All existing authorisations, Part IV permissions, controlled functions, rule waivers and modifications, passports, limitations and requirements will be grandfathered. Firms do not need to take any action to transfer their existing regulatory approvals to the new regulators.

Next steps

The BoE and the FSA plan to publish more consultations over the next few months and to notify firms of new requirements as they transition the FSA's operations and interactions with regulated firms to the new regime. At this critical stage firms still have a unique opportunity to inform and shape the regulators' approaches. This may be the last such opportunity for some time, as the new regulators may get stuck in quickly to develop their own regimes and to distance themselves from the FSA's perceived failures.

Both firms and regulators will have a steep learning curve as they get to grips with the new regime. Regulators will need to efficiently apply the new regulatory framework and make dual regulation work. Firms will need to consider the impact of the new regulatory approaches and changes to regulatory processes on their businesses, in particular how their strategy, business model, culture, products and services may be viewed by the FCA and PRA. Firms will want to understand the new framework, the division of responsibilities, how they will be supervised, and how the regulator's expectations are changing to maintain a good rapport with their supervisors and achieve good outcomes for their customers.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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