Some unfinished business
On 1 April 2013 the Financial Services Act 2012 came into force, removing the Financial Services Authority (FSA) from the scene and delivering a new regulatory structure for the UK, comprising the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).This briefing note, published on 28 March 2013, explores some of the unanswered questions about how the new regulators might operate.
It is commonly referred to as a "twin peaks" structure, with the PRA responsible for the prudential supervision of banks, insurance firms and the largest investment firms and the FCA responsible for conduct and markets, along with the prudential supervision of all other firms. In reality, the picture is more complicated, with the Bank of England's Financial Policy Committee (FPC) taking on formal responsibility for macro prudential supervision and the Bank itself becoming the supervisor of central counterparties (CCPs). And of course HM Treasury will continue to have a controlling interest in terms of the overall legislative framework.
The journey to the new regulatory structure began in June 2010 with the Chancellor's Mansion House speech. Since then there has been no shortage of consultations, debates, speeches, conferences and roadmaps. In addition, the FSA has for the last year been operating an internal twin peaks structure, having split itself into two main business units foreshadowing the PRA and FCA. So there will be no supervisory "Big Bang": instead, when the new regulators open their doors there will be a degree of familiarity in terms of their stated philosophies and supervisory approaches. But familiarity should not lull regulated firms into a false sense of security. Increasingly, key issues are being decided outside the UK, and experience suggests that regulators around the world retain the capacity to surprise. Moreover, notwithstanding the volume of material that has so far been published both by and about the new UK regulators, there is no shortage of unanswered questions about how they might operate.
We explore some of these below, in no particular order of priority.
The unanswered questions...
1. What do the new regulators' judgment based
approaches mean and what sort of procedures will they need in place
to make them work?
Judgment based supervision is a cornerstone of both PRA
and FCA supervision, based on the availability of seasoned, senior
supervisors who are able to focus on a small number of material
risk issues that really matter to the regulators' objectives.
This is potentially a very powerful approach. But with judgment
comes significant discretion, so how the PRA and FCA deliver
predictability so that firms know what to expect and how they
deliver consistency in their interpretations will be key.
2. How will the FCA meet its new competition
mandate?
This is a new area for the FCA and there is no doubt that
it will be a very important one. How will the FCA go about this
task, and how will it balance the need to foster competition
against powers such as those to intervene directly in markets, and
in extremis to ban certain products or services rather than rely on
market forces? There is scope for this balance to be struck
differently in wholesale and retail markets, but it is the FCA who
will have to address the inevitable boundary issues.
3. How will the new regulators (PRA, FCA, FPC and Bank)
co-operate?
Co-operation and co-ordination between the regulators
will be essential, as the legislation and the various memoranda of
understanding recognise. But writing something down does not of
itself make it happen - there has to be a will to co-operate, led
from the top of the organisations. One test of this will be in the
supervision of CCPs. This will be done by the Bank. Policy will be
driven in many respects by the European Securities and Markets
Authority (ESMA), on which the UK is represented by the FCA. The
main clearing members of the CCPs will be supervised by the PRA.
And CCPs, as systemically important financial institutions, will be
of great interest to the FPC from a systemic risk perspective.
Ineffective co-ordination here could have very serious
consequences, as could inadequate sharing of knowledge, e.g. for
the non-bank sector. Co-operation and co-ordination in both this
and other areas will also be essential to securing effective UK
representation in Europe.
4. How will the FCA use behavioural economics to inform
its approach?
This is a fascinating new area for the regulator and
Martin Wheatley, CEO designate of the FCA, has already signalled
the FCA's intention to spend time understanding the behavioural
economics influencing (retail) consumers when buying products,
taking account of individual investor financial awareness and
education (or lack thereof). Some of the behavioural tools, such as
default setting (e.g. automatic enrolments), are potentially very
powerful, but may raise further questions about how
"paternalistic" a regulator should be.
5. How will the PRA's risk assessment framework
operate, especially the resolvability assessment element for
insurers?
Firms have had a number of years in which to become
accustomed to the FSA's ARROW approach. Its PRA successor looks
similar in some respects, but a completely new element is its
resolvability assessment. Banks, through their Recovery and
Resolution Plans (RRPs), are familiar with this concept, but its
application to insurance firms is much less clear. And, in the case
of both banks and insurers, how the resolvability assessment will
influence supervisory intensity remains to be seen.
6. Will the PRA's Proactive Intervention Framework
(PIF) deliver its intended outcome?
In the debates that led to the formation of the PRA, the
Bank made no secret of its concerns about "supervisory
forbearance" and "regulatory capture" - that
supervisors would, for whatever reason, give firms too much benefit
of the doubt. In future, each firm will be allocated to one of the
five PIF stages (stage 1 is low risk to viability of firm and stage
5 is resolution / winding-up under way), but the PRA has indicated
that it will not inform the firm of which stage it is in. (It
remains to be seen if that approach is sustainable.) To guard
against the risk of forbearance, where actions expected in a
particular PIF stage have not been taken, the supervisors must
report to senior management.
7. How much more and what sort of data will be collected
and analysed by the PRA, FCA and FPC?
The new regulators have said a lot about the importance of data
and how data will inform and influence their new approaches. If the
regulators are going to be fleet of foot, identifying and dealing
with risks well before they become significant issues, then
capturing and analysing the right data will be key. But the
PRA's consultation paper on data, originally promised for legal
cutover, has not yet appeared and has dropped off the forward
calendar. There has also been very little from the FPC and FCA on
this subject. Given the systems implications and costs associated
with new data reporting requirements this is definitely an area to
watch. There is also a question about the extent to which the UK
regulators will be constrained by data requirements set at the EU
level.
8. How will the "super-complaints" procedure
work in practice, especially now that the bodies to be designated
can include those representing SMEs?
The new procedure will allow designated bodies representing retail
consumers and SMEs to put formal complaints to the FCA to which it
must respond, one way or the other, within 90 days. This is
entirely consistent with the Government's desire to give
consumers a louder voice; the extension to SMEs no doubt reflects
learning from current work on the possible mis-selling of interest
rate hedging products to that group. Will the FCA be inundated with
super complaints, or will they be more of a trickle? Experience at
other UK regulators which have this procedure suggest the latter.
But given the public and political focus on financial services and
how much "heat" they generate, it would be premature to
rule out the prospect of a flood.
9. What is the significance of the new "business
model" threshold condition (TC) and how will it be applied to
existing as well as to new firms?
The Act contains a new TC which, as with all others, must be met
continuously from the point of authorisation onwards. This TC
concerns the suitability of a firm's business model and the FSA
has helpfully consulted on draft guidance on how this is to be
interpreted. Given the fact that the FSA has been paying much more
attention to business models because of the banking crisis on the
one hand and PPI on the other, there may be less of a step change
here than would otherwise have been the case. But it remains to be
seen just how willing to intervene the new regulators will be when
it comes to firms' business models and strategies.
10. What appetite does society really have for the
"orderly failure" of financial services firms?
Both the PRA and the FCA make much of their intention
that firms can and should be allowed to fail in an orderly manner.
This is consistent with introducing greater competition into the
market. There are signs this will indeed happen, for example with
the FSA indicating a willingness to lower the regulatory barriers
to entry for start-up banks. Moreover, the emphasis from both the
PRA and FCA on resolution planning indicates that they are clearly
serious in this regard, as is to be expected after a financial
crisis in which it became clear that major banks, and brokers
holding client money, did not fail in an orderly way. However, will
society tolerate the failure of financial services firms, even if
they are orderly? Or will the PRA and FCA find themselves reporting
frequently on "regulatory failures" as they will be
required to do under the new Act? If so, this could have seriously
negative consequences - for competition; for the amounts of capital
and liquidity that firms would have to hold to reduce the
probability of their failure still further; and, more widely, for
supervisors' willingness to take decisions that balance these
risks against the interests of the wider economy.
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