A New Era for UK Financial Regulation

This post comes to us from Chris Bates, a partner in the London office of Clifford Chance, and is based on a Clifford Chance client briefing by Mr. Bates, Carlos Conceicao, Simon Gleeson, Michael Smyth and Max Savoie. The post relates to a recent speech by the UK’s Chancellor of the Exchequer, George Osborne, which is available here.

On 16 June 2010 the UK’s Chancellor of the Exchequer, George Osborne, unveiled sweeping reforms to the way financial institutions will be regulated in the UK in his first annual ‘Mansion House’ speech. The Chancellor plans to dismantle the Financial Services Authority (FSA), the current UK integrated regulator of firms and markets, and the UK’s tripartite system of regulation. Prudential supervision will be transferred to a new body under the Bank of England and a separate agency will be created to tackle serious economic crime. The other functions of the FSA will be organised in a new Consumer Protection and Markets Authority. The Chancellor promised to implement these and other changes to the UK’s regulatory architecture by the end of 2012. The Financial Secretary to the Treasury, Mark Hoban, has now also made an oral statement in Parliament giving further details of the government’s plans.

Macro- and micro-prudential regulation moved to the Bank of England

The government’s May 2010 coalition agreement, ‘The Coalition: our programme for government’ said that the Bank of England would be given control of macro-prudential regulation and oversight of micro-prudential regulation. The latest announcement goes beyond this to bring the government’s plans more closely in line with those set out in the Conservative Party’s pre-general election financial services manifesto (‘Change for the better in Financial Services’, April 2010), which more clearly envisaged the split-up of the functions of the FSA between the Bank of England and another new agency.

Under the Chancellor’s plans, supervisors from the FSA will move to a new Prudential Regulation Authority, which will be a subsidiary of the Bank of England, to carry out prudential regulation of financial firms including banks, investment banks, building societies and insurance companies. The aim is to ensure that the Bank, as the lender of last resort, obtains first-hand knowledge from its new subsidiary of the health of the banks and to ensure that it is clear who is in charge in a crisis. Hector Sants, the current chief executive of the FSA, will stay on to oversee the transition and will become the new chief executive of the Prudential Regulation Authority and a Bank of England deputy governor. Andrew Bailey, Executive Director of Banking and Chief Cashier at the Bank, will be his deputy. The Financial Secretary has also confirmed that the Governor of the Bank of England will chair the board of the new Prudential Regulation Authority and the new Deputy Governor for financial stability will also be a member of the board.

An independent Financial Policy Committee (FPC) will be established at the Bank to ‘look across the economy at the macro issues that may threaten economic and financial stability and take effective action in response’. The Financial Secretary confirmed that the FPC will be chaired by the Governor of the Bank of England and will include the Deputy Governors for monetary policy and financial stability, the chair of the new Consumer Protection and Markets Authority as well as external members and a Treasury representative (and that an interim FPC will be set up in the autumn, in advance of legislation). It is expected that the FPC will monitor overall levels of debt and other systemic risks in the economy but the Chancellor also says that it will be given the tools and the responsibility to tackle these risks.

The Governor of the Bank of England, Mervyn King, in his speech at the Mansion House, cast more light on this aspect of the proposals. He said that regulation will reflect ‘two different but complementary perspectives: a bottom-up perspective, focused on setting institution-specific capital requirements, and an overall perspective with a set of system-wide capital requirements that vary over the economic cycle’. The FPC will make the judgements on the level of these capital buffers with the aim being to tighten and relax capital standards in response to changing credit conditions, but there is no indication as yet that the macro-prudential tools will include other levers over credit growth (such as powers to limit loan to value ratios on mortgages). The Financial Secretary has also confirmed that the FPC will have powers to require the Prudential Regulation Authority to implement its decisions ‘by taking regulatory action with respect to all firms’. This may address some of the concerns that macro-prudential tools of the kind recently aired by the Bank of England could be applied to individual firms in a way that might be regarded as anti-competitive or simply unfair.

The Governor accepts that the proposed macro-prudential powers are largely untried and untested but the proposals reflect many of the same ideas as set out in a paper by Sir Andrew Large published by the Centre for the Study of Financial Innovation (CSFI) the morning before the Chancellor’s speech (‘Systemic policy and financial stability: A framework for delivery’), which also recommended the location of macro-prudential powers within a separate committee within the central bank and the use of discretionary capital buffers as the macro-prudential policy instrument.

The Chancellor’s proposals leave open for discussion whether and how to respond to the presence of foreign banks operating in the UK, particularly those operating under the EU passport regime that are not subject to the full range of UK prudential supervision. Clearly, there is a role for the FPC in liaising with the proposed European Systemic Risk Board (ESRB), which may be given powers to make recommendations to Member States on, among other things, the financial situation of specific institutions, the potential existence of asset bubbles, and the functioning of market infrastructure, although it is not currently envisaged that the ESRB would have binding powers. There is as yet no international or EU consensus on the type or role of macro-prudential tools in the capital framework and any UK approach could be overtaken by the European Commission’s proposals for a more harmonised ‘single EU rulebook’ for regulatory capital as part of its proposed ‘CRD4’ package for revising the EU Capital Requirements Directive (or the parallel work being done by the Basel Committee). In addition, the Chancellor’s proposals leave open for discussion whether increased regulation of banks requires a further extension of the regulatory ‘perimeter’, for example, to bring more non-bank lenders within the scope of prudential supervision.

FSA replaced by new consumer and financial markets regulator

The FSA will be abolished and replaced by a Consumer Protection and Markets Authority, which will ‘regulate the conduct of every authorised financial firm providing services to consumers’ and be responsible for conduct of business regulation of both retail and wholesale financial services. The inclusion of responsibility for markets regulation resolves the gap in the Conservative Party’s pre-election proposals which did not indicate which agency was to be responsible for markets.
Stripping the FSA of its prudential regulatory role reflects one of the trends noted in the G30 report of January 2009 (‘Financial Reform: A Framework for Financial Stability’) and parallels the Australian and Netherlands ‘twin peaks’ model of regulation. It will also leave the Bank of England as the primary supervisor of life insurance companies in line with the Solvency II approach of approximating insurance and bank prudential regulation. However, the reforms appears to be at odds with the proposed EU system, where the functions of the proposed European Supervisory Authorities are divided by industry sector (banking, securities and insurance) rather than by regulatory function, and marks a reversal of the trend of the past decade for the consolidation of regulatory functions in unitary regulators. The separation of functions will require clear institutional arrangements between the two agencies to manage conflicts in cross-over areas, such as responsibilities for authorisation and the prudential supervision of exchanges, clearing houses and other market infrastructures (a point flagged by the FSA in its response to the Chancellor’s speech).

A ten point plan issued by the Financial Services Consumer Panel (FSCP) ahead of the Chancellor’s speech called for more ‘one stop regulation’ and argued that the FSA should regulate consumer credit for all FSA regulated firms, as envisaged by the Conservative Party’s pre-election proposals. The FSCP also advocated effective product scrutiny, higher compensation limits, and separate authorisation of each retail brand.

The Financial Secretary has confirmed that the new Consumer Protection and Markets Authority will maintain the FSA’s responsibility for the financial ombudsman service, the new consumer financial education body and the financial services compensation scheme, where it will work closely with the FPC and the Prudential Regulation Authority. It will have ‘a strong mandate to ensure that financial services and markets are transparent in their operation’, and is to take a ‘tougher, more proactive approach to regulating conduct’. Its primary objective will be ‘promoting confidence in financial services’. Like all the other new bodies, the new Authority will be accountable to Parliament.

A new white collar crime agency

The Chancellor pledged to create a single agency to tackle serious economic crime. This was promised in the coalition agreement and based on pre-election Conservative Party policy. It is likely to replace the white collar crime enforcement functions of the Serious Fraud Office, the FSA, the Office of Fair Trading (OFT), the Fraud Prosecution Service, and the Crown Prosecution Service Revenue and Customs Division.

Timetable for reform

The Financial Secretary has indicated that the government will ensure the passage of the necessary legislation within two years (a bill had been scheduled for this Parliament in the Queen’s speech). He also committed to a full and comprehensive consultation process and a detailed policy document for consultation before the summer recess. The Financial Secretary also stated the aims of minimising uncertainty and transition costs for firms, maintaining high quality focused regulation during the transition and providing as much clarity and certainty as possible for FSA, Bank of England and other affected staff during the transition. The aim remains to get the new regime operational by the end of 2012.

Restructuring the banks

The government appointed an Independent Commission on Banking on the day of the Chancellor’s speech to review possible structural measures to reform the banking system and promote stability and competition, including the complex issue of separating retail and investment banking functions of the UK’s largest financial institutions. The Commission, which will publish its final report by the end of September 2011, will consider whether to force such institutions to split their retail and investment banking arms. It is also charged with promoting stability and competition in banking and will consider the extent to which large banks gain competitive advantage from being perceived as too big to fail as well as the risks to the government’s fiscal position resulting from its recommendations. The appointment of Sir John Vickers, former head of the OFT, as chair of the Commission is an indication that the government considers this a priority. Sir Vickers will be joined by Martin Taylor (former Barclays chief), Claire Spottiswoode (ex-head of Ofgas), Bill Winters (former co-head of investment banking at JP Morgan) and Martin Wolf (columnist), all of whom were named as commissioners by the Chancellor.

The Chancellor has been under some pressure to commit to breaking up the banks. A cross-party group, the Future of Banking Commission, published a report on 13 June 2010 recommending ‘a structural solution to the problems caused by large integrated banks’ and calling for an extension of the Volcker rule ‘to prohibit banks that advise clients from trading any form of securities’ and for the separation of corporate and investor advice. The business secretary Vince Cable was a member of that commission. However, a radical restructuring of Britain’s largest banks still seems far from inevitable, given the absence of international agreement, the EU constraints on unilateral UK action, the cost to the taxpayer as the owner of significant stakes in banks and as a stakeholder in the UK’s financial centre and the fact that smaller, more focused institutions do not necessarily present less systemic risk and may risk being too small to succeed, even if not ‘too big to fail’.

A bank levy and pay restraint

The Chancellor also promised to introduce a bank levy and to demand further restraint on pay and bonuses but did not go into detail on either of these.

It is expected that the government will introduce a levy on bank balance sheets, the details of which will be announced in the emergency Budget on 22 June 2010. A levy on balance sheets would follow the approach taken by Sweden and be in keeping with the direction of the principles for banking levies recommended by the IMF and being negotiated by the G20. However, a levy based on balance sheet size risks deterring asset intensive (but low margin) activity and unrelieved double taxation (especially if applied to consolidated balance sheets) as other countries may also seek to tax local bank branches or subsidiaries. However, much depends on the size and structure of the levy. In addition, the government differs from the European Commission in that it wishes to use the levy to supplement general government revenue, whereas the European Commission is seeking to debate the creation of resolution funds supported by levies on banks.

The Future of Banking Commission called for remuneration structures for senior executives to be far longer-term in nature, with reward for financial measures aligned to return on assets and the creation of sustainable shareholder value over five and ten year periods. The Commission’s report also recommended that there should be no reward for increasing return on equity or earnings per share and that remuneration in the retail sector should be more closely linked to customer satisfaction. However, the work at international level, under the auspices of the Financial Stability Board, has taken a somewhat different approach. In addition, the European Commission has launched a new initiative on corporate governance within financial institutions which also aims to change remuneration policies in companies in order to discourage excessive risk taking. The debate is likely to continue as few think that there is a simple solution to the issues around remuneration that will satisfy all parties.

The Chancellor’s speech can be found here and a summary of the Governor’s speech here.

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