Triplets?. . . ‘No, I’d Rather Have Twins’ — The UK’s Blueprint for Financial Regulation

July 8, 2010

In a dramatic move, initially trailed this time last year, the Conservatives (now in coalition with the Liberal Democrats) have confirmed that they will in their term of service, abolish Britain’s tripartite financial services regime, to replace it with a form of "twin peaks" style of regulation.

Why, many have asked, would the UK Government tear apart (with substantial cost to firms and the market generally) a system it had, just over thirteen years ago, proudly introduced to the international regulatory landscape. The UK’s Financial Services Authority (FSA) made its debut in 1997 by consolidating under the authority of this new "supra regulator" various regulatory functions that had been dispersed across several separate supervisory agencies (some self-regulatory in nature) with no integrated approach. Soon thereafter, an overhaul in the regulatory system was effected when the Financial Services and Markets Act 2000 (FSMA) was promulgated. Pursuant to this an extensive set of supporting regulations (covering everything from firm authorizations, capital and liquidity requirements, market transparency and consumer protection rules) were adopted by the FSA which was also tasked with enforcing its 5,000+ page rule book . The FSA model has been adopted as a template by many other international regulatory bodies since its inception and indeed tailored versions of the FSA’s weighty rulebook exist in a number of jurisdictions today across the globe. So why would the UK Government turn its back on this stellar effort which has won worldwide acclaim?

This article looks at the current UK system of regulation, the reasons for the proposed changes and takes a glimpse at the new regulatory landscape ahead.

Reason

"The financial crisis was not a failure of regulation, but a failure of supervision.  . . . we need better supervision of the risks being run by financial institutions and the systemic risk in the sector as a whole. The FSA is not the right body to do this. Instead of it being expanded, the FSA should be scaled back to what it can actually achieve . . .".  This was the view of Dr Eeamonn Butler of the Adam Smith Institute in a response paper issued in Jun 2009 to the proposals issued by the FSA in 2009[1]. This certainly was a view echoed by the Conservatives before they came into power, and in his speech at The Lord Mayor’s Dinner for Bankers & Merchants of the City of London (almost exactly one year later) on 16 June 2010, the Chancellor of the Exchequer, George Osborne, formally committed the coalition government to a determined action to resolve the crisis. Somewhat excessively, Osborne is of the view that we have seen in the UK is a system of regulation that failed "so spectacularly". Osborne has "profound doubts about the tripartite system" and appears to share some of the views of the academics of the Adam Smith Institute — ". . . the very design of the policy framework meant that responding to an explosion in balance sheets, asset price and macro imbalances was impossible".

Wrongs of Today

Each of the "Tripartite Authorities" — the Bank of England (BoE), Her Majesty’s Treasury (HMT) and the FSA — has a role in ensuring the stability of the UK financial system. The arrangements outlining how the Tripartite Authorities work together are set out in a memorandum of understanding originally agreed in 1997 and subsequently amended in 2006 (MoU).

Under the MoU, the BoE’s responsibilities are summarized as contributing "to the maintenance of the stability of the financial system as a whole". The FSA’s powers and responsibilities stem from the FSMA, and the FSA has the responsibility of authorizing and supervising individual banks. HMT has responsibility for the institutional structure of the financial regulatory system, and the legislation behind it. In a crisis, the FSA would, according to the MoU, be responsible for "the conduct of operations in response to problem cases affecting firms, markets and clearing and settlements systems within its responsibilities" which it may undertake by "the changing of capital or other regulatory requirements and the facilitation of a market solution involving, for example, an introduction of new capital into a troubled firm by one or more third parties". However, the BoE would remain in charge of "official financial operations . . . in order to limit the risk of problems in or affecting particular institutions spreading to other parts of the financial system".

Well how did the Tripartite Authorities work in practice? According to Osborne:

"The Bank of England was mandated to focus on consumer price inflation . . . to the exclusion of other things. The Treasury saw its financial policy division drift into a backwater. The FSA became a narrow regulator, almost entirely focused on rules based regulation. No one was controlling levels of debt, and when the crunch came no one knew who was in charge."

Rights of Tomorrow

The architecture of the new financial regulatory system proposed for the UK is based on the "twin peaks" style of regulation — in which prudential supervision is separated from markets and consumer protection — a model used in a number of other jurisdictions including The Netherlands and Australia.

• New powers for the Bank of England

  Will be responsible for monetary policy, financial stability, macro-prudential supervision and will oversee micro-prudential supervision

• New Prudential Regulatory Authority (PRA)

  Will operate as a subsidiary of the BoE and will carry out the prudential regulation of financial firms including banks, investment banks, building societies and insurance companies

• New Financial Policy Committee (FPC)

  Will also report to the BoE and will have the tools and responsibility for macro issues that threaten economic and financial stability

• New Consumer Protection and Markets Agency (CPMA)

  Will regulate the conduct of every authorised financial firm providing services to consumers. Will also be responsible for ensuring the good conduct of the UK’s retail and wholesale financial services. The FSA will be abolished and most of the FSA staff (at least on the enforcement side) is expected to move across to the CPMA.

• New Economic Crime Agency (ECA)

  Will be responsible for tackling serious economic crime that is currently dispersed across a number of Government departments and agencies. The expectation is (though it is yet to be confirmed) that the work currently undertaken by the FSA, the Serious Fraud Office, the Office of Fair Trading and the Serious Organised Crime Agency will be merged into a single umbrella of the ECA. Whilst HMT has confirmed that the ECA will be prosecuting insider dealing and market abuse — it is not clear who will be responsible for fraud, bribery, corruption and cartel activity.

• The (not so) new players
• Mervyn King, Governor of the Bank of England, will also become Chair of the new FPC and PRA and will be the "King of the City").
• Hector Sants, the respected and robust recent head of the FSA, a hitherto vociferous defender of the FSA and the current system of regulation — seemingly nailed his cards to the ground when he publicly stated — "There are different types of high-level organisational structures around the world but regardless, the best supervision is always a system of integrated risk assessment, with a high level of interdependence between prudential and conduct risk". Sants stated he was convinced that undoing the integrated system of regulation would take the UK back to the dark ages. A year on however and he appears to have changed his tune. In one of the smartest moves of the new government, Osborne has managed to convince Sants to stay on as Chief Executive of the FSA and Sants will in due course assume the top job at the PRA.

The process will be completed by 2012.

Unanswered Questions

The canvas is still largely blank. However rather than delving into the long list of unanswered questions (e.g. is every firm, including small firms, be subject to dual regulation by the BoE and the CPMA? who will enforce cartels? will there be a new rule book? if the CPMA is to be "independent", who will appoint its head? how will the transition process work?) — we only need to wait (we are told) a few more weeks as a consultation paper has been promised before the end of the Parliamentary summer recess[2]. Jolly beach time reading . . .