Banking and Capital Markets Insight, October 2010

Financial regulation in the UK – How will the new structure work?

It is understandable that regulation is in the spotlight, given the scale of the financial crisis and the strains it has potentially placed on the public purse. But it is not only regulatory policies and supervisory practices that are under scrutiny. So too are the regulators themselves, and the structures in which they operate.

This is most clearly seen in the UK. In June, the Chancellor announced that the FSA would cease to exist in its current form, and would be replaced by a new Prudential Regulation Authority (PRA), which would be a subsidiary of the Bank of England, and a "powerful new" Consumer Protection and Markets Authority (CPMA). Systemic risk would be addressed by a Financial Policy Committee (FPC) at the Bank of England. He indicated that the transition would be complete by 2012.

On 26 July HM Treasury issued a consultation paper, entitled "A new approach to financial regulation: judgement, focus and stability". It gave further details of the proposals, with a separate consultation on whether to create a single agency to tackle serious economic crime.

The new structure is set out in the diagram on the following page.

Key issues Transition

Many of the important issues in any restructuring relate to the transition. In this particular case there is a risk that the essential tasks of reforming policy, agreeing it internationally, and implementing it effectively will be disrupted by these changes. There are also personnel and systems issues, both in splitting the FSA into two or more units and in integrating the arrangements of the PRA with those of the Bank of England, and the need to consider whether to "grandfather" existing authorisations and permissions.

Although the need to address these issues is widely understood, the success or otherwise of the project will depend on how well they are tackled in practice.

Structural issues

But not all of the issues relate to the transition. There are also questions about how these arrangements will work in the longer term.

These can be grouped under four headings: governance; scope and possible overlaps; objectives of each agency; and relations with others.

1. Governance

   The governance issues relate to each of the new bodies – the PRA, CPMA and FPC.

   In his Mansion House speech, the Chancellor said it was only central banks that had the broad macroeconomic understanding and authority needed to make macroprudential judgments. Moreover, in order to manage crises effectively, they needed to be familiar with the institutions they dealt with, and "so they must also be responsible for day-to-day micro-prudential regulation as well."

   As a result the PRA will be a subsidiary of the Bank of England, with a board chaired by the Governor, and will implement the macro-prudential decisions of the FPC. But in all other respects the Treasury paper states that the PRA will have operational independence for the day-to-day regulation and supervision of firms, with a majority of non-executives on its board, and with the Bank having no formal power of direction over it. It remains to be seen how this will work in practice.

   Moving on to the CPMA, the Government proposes an operationally distinct and "strong" markets division to lead on all market conduct regulation, and represent the UK in the European Securities and Markets Authority. However, this separate identity is not buttressed by any independent board or corporate structure, so it is as yet uncertain how this will operate.

   Finally, it is unclear whether the FPC will be a "Committee of Court" – i.e. with non-executive membership entirely comprised of those already on the board of the Bank of England – or whether it will follow the same model as the Monetary Policy Committee, where the independent members do not serve on the main board.

2. Scope and overlaps

   The Treasury paper describes the FSA as "monolithic", arguing that prudential and conduct-of-business supervision require different skills, approaches and cultures. Nevertheless, others have noted that the theoretical advantages of an integrated supervisory model are considerable, and the PRA and CPMA will need to share information and collaborate in as effective a fashion as possible to achieve these synergies, and reduce both over and under-laps. Moreover, some small firms will not be supervised by the PRA for prudential purposes, giving scope (in theory at least) for some inconsistency here.

   In the past, some commentators suggested that giving an independent central bank responsibility both for monetary policy and financial supervision risked too great a concentration of power, and/or a lack of focus on (or conflict between) one or other function. While the potential for conflicts may have been overstated, the Bank and PRA still need the capacity to operate effectively across this wide range of roles, which is daunting given the variety of decisions that prudential supervision entails.

3. Objectives of each agency

   The Treasury paper describes the CPMA as a "strong consumer champion" although it notes that the Financial Ombudsman Scheme will only be credible if it does not favour, or appear to favour, consumers. Given its powers to act against firms, the CPMA too needs to show that its rules and actions are balanced and proportionate. Whether this can easily be done as "consumer champion" remains to be seen.

   Rather different issues arise with the FPC. Until the macro-prudential tools it will deploy have been identified in more detail, it will be difficult to decide whether its objectives are unduly ambitious or not.

   More generally, it has not yet been decided whether to supplement each body's primary objective with secondary factors, such as competitiveness or innovation. If so, should these considerations be subservient to the primary objective (which would make the regime less flexible, but clearer) or should an alternative approach be adopted?

4. Relations with others

   Clearly UK regulators need to interact effectively with opposite numbers overseas. This issue is addressed in the Treasury paper, and there is no reason to believe that the new arrangements cannot be made to work effectively.

   But it will also be important for the CPMA and PRA to work together so that firms do not face clashes in terms of data requirements, meeting requests, supervisory demands and so on. In other words, effective relationship management with the industry will be important to the success of the new structure.

   Conclusion

   The Government has stated its commitment to a full and comprehensive consultation on these proposals. It is likely that many of the issues discussed above will feature in these discussions.

   Beyond Basel III: The FSA recommends further major changes to the capital regime

   "Since the financial crisis began in mid-2007, the majority of losses and most of the build up of leverage occurred in the trading book", so wrote the Basel Committee on Banking Supervision in January 2009. The Committee went on to acknowledge that shortcomings in its capital framework for market risk – unchanged since its introduction in 1996 – had been an important contributory factor and announced a two stage plan of corrective action:

   Stage 1: this involved correcting or mitigating a number of specific deficiencies it identified in the framework and was completed in July 2009 for implementation by 1 January 2011. Key measures taken at this stage included introducing a stressed value at risk (VaR) requirement, extending the scope of the incremental risk charge to cover rating migration risk, and requiring most securitisation positions to be subject to banking book capital requirements.

   Stage 2: recognising the partial nature of the steps taken at stage 1, the Committee announced that it would be "initiating a longer-term, fundamental review of the risk-based capital framework for trading activities".

   Although the Committee has not itself said another word on the matter, our own FSA – unsurprisingly given the importance of banks' trading activities to London – has not let the idea of a fundamental review drop. In March 2009, the Turner Report called for "a more radical review of trading book risk measurement and capital adequacy requirements" to be conducted at international level and completed within one year. While this target date is long past, the FSA has not been idle, with its work culminating in a substantial discussion paper in August, "The prudential regime for trading activities – A fundamental review".

   As Basel III and the Banking Commission assume centre stage, the paper is probably in danger of not receiving the attention it merits. That would be unfortunate as it is important, for two main reasons. First, it raises the question whether fundamental weaknesses in the prudential regime for trading activities remain, even after the July 2009 amendments. Whatever the answer ultimately reached, it is better that it is reached after proper consideration. Secondly, in offering thoughts on how the prudential regime for trading activities may be strengthened, the paper is relevant to the question of whether those activities should be separated from the utility functions of banking and hence, to...