The Future of UK Regulation (FSA Speech)

Margaret Cole, Interim Managing Director, Conduct Business Unit at the Financial Services Authority (FSA), gave a great speech at the Financial Services Club last week. 

Margaret's Conduct Business Unit will become the Financial Conduct Authority in 2013, when the Financial Services Authority splits into two units.

Everyone is interested to know what this means, but the presentation Margaret gave was under the Chatham House Rule so I'm not going to repeat it all here.

Instead, I've stolen another FSA speech in the public domain given at the British Bankers Association's meeting recently, and it covers some of the ground Margaret covered, although she was far more frank and open due to the Rule being in force.

Worth a read regardless ...

Thank you for the invitation to speak today.

I would like to focus my remarks on the changing shape of banking regulation in the UK. The essence of these changes gives the Bank of England overarching responsibility for financial stability through the creation of the Financial Policy Committee and establishes what is known as a ‘twin peaks’ style of firm-specific regulation.

In this structure, as I am sure you know, the prudential oversight of banks and insurers will be provided by a subsidiary of the Bank of England, the Prudential Regulation Authority. The oversight of conduct and markets, along with the prudential regulation of other financial firms, will be delivered by a new independent regulator, the Financial Conduct Authority. The FCA will be the successor body to the FSA. It is the intention that this new structure will become effective in the first half of 2013.

The government’s vision for how the new regulatory structure will work is laid out in its White Paper, published earlier this month. The FSA and the Bank of England have also published documents laying out the approach that the PRA will adopt for the prudential regulation of banks and also insurers. These have been complemented by an FSA publication earlier this week which outlines our initial thinking on the FCA

My intention today is to give you an overview of the approach that the new authorities will take to banking regulation, the detail of which are laid out in this set of publications.

The need for change

My principal message today is to say we must use the opportunity presented by these reforms to force ‘root and branch’ change both by regulators and banks. This root and branch change must affect both the behaviours and the processes of banks and regulators. Unless we all change all aspects of what we do, real change will not be achieved.

The financial crisis has demonstrated that significant change is needed in relation to prudential issues – but I want to remind you that we also need significant change to occur in relation to conduct issues. In the last couple of decades, at least £15bn of redress has been paid out to consumers in response to the conduct failures of firms and if we include PPI this number is likely to exceed £20bn. This is an unacceptable cost to both consumers and bank shareholders and it is also a visible demonstration of why trust has been lost between the users of the financial services marketplace and the firms operating within it.

In addition to making changes to the way in which we all behave and operate, we also need to ensure there is clarity of understanding by society and Parliament as to our collective purposes and accountability framework. This is important not just for the regulators but also, in my view, for the industry.

Before outlining the supervisory approaches of the PRA and FCA, I would like to highlight some of the key issues or perhaps trade offs that society will need to consider when addressing the question of the regulators’ purpose and accountability framework. I touched on these yesterday at the FCA conference, but I think it is worth revisiting these crucial issues.

• Firstly, the trade off between responsibility and suitability. This is primarily a question for the FCA. The key question here that society must answer is: to what degree should individual consumers be held responsible for, and given the freedom to, make their own decisions? Given the known asymmetry of information between the consumer and the manufacturer, it has been generally accepted that a degree of judgement on suitability should be made by the regulator. While the FSA’s approach in the past has been to ensure disclosure of risks and information to consumers, experience has shown that in practice consumers pay scant attention to the material provided to them at the point of sale and in many cases lack the technical skills to evaluate the information. The FCA is likely to make more suitability judgements and thus run the risk of being accused of reducing personal freedom.
• Secondly, the trade off between intervention and innovation and its associated cost. Central to the proposed new model for both authorities is the concept of early intervention. This is likely to be most controversial in respect of the FCA, where early intervention will include banning individual products where the regulator judges that the risk of mis-selling significantly outweighs a product’s utility, and intervention to ban individual firms from selling perfectly useful products where their sales processes look likely to lead to significant mis selling. Clearly the intended benefit of such interventions is to choke off the detriment that the mis-selling would cause. The underlying premise is that the regulator is able to successfully identify that detriment is going to occur. Unfortunately, that will not always be the case and thus undoubtedly at times the intervention itself runs the risk of creating more harm than good. It could be seen to reduce innovation, choice, competition and potentially raise the cost of regulation since the FCA would undoubtedly need more resources than we currently have to enable it to make such judgements.
• Thirdly, a word on transparency and efficiency. Here I am sure the trade off is very obvious. Namely, transparency does in general promote confidence, help equip consumers to make better decisions and is in tune with the expectations of modern society. However, there is a risk that such transparency will hamper the efficiency of the regulator and potentially lead to problems in the marketplace linked to the unintended consequences of consumer actions. This is an issue for both the PRA and FCA – both are committed to more transparency, the question is: how much?
• Fourthly, the trade off between cost and effectiveness, which is relatively straightforward. A more interventionist and proactive regulator offers the prospects of greater success but comes with the risk of extra regulatory costs. In the case of the FCA, it seems likely that the extra capabilities needed to deliver against its expanded mandate will increase its cost relative to the FSA, but your feedback will be invaluable in determining the extent of that change. In the case of the PRA, the FSA has already invested in expanding its prudential capability and thus this should be less of an issue.
• Finally, let me talk about accountability and judgement. The trade off here is that we want both regulators to make difficult, brave and forward-looking judgements and inevitably with hindsight some will prove not to lead to the desired result. Furthermore, if every time this happens politicians and commentators leap to the conclusion, without considering the evidence, that the regulators have failed, it will be more difficult to attract and retain capable individuals for those roles.

Let me now make some remarks on the operating models of the PRA and FCA.

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The PRA’s objective

Turning first to the PRA. It will be the prudential regulator for just over 1,000 deposit-takers. The PRA will have a single objective – to promote the safety and soundness of regulated firms – and will meet this objective primarily by seeking to minimise any adverse effects of firm failure on the UK financial system and by ensuring that firms carry on their business in a way that avoids adverse effects on the system.

This purpose is fundamentally different from that of previous regulatory regimes and will lead to a material change to the model of supervision which was in use prior to the financial crisis. I will outline this new model for you in a moment, but first I would like to make four points that arise from the PRA’s objective.

• Firstly, it is clear that the purpose of the PRA is to focus on the stability of the system overall, albeit through firm-specific supervision. This will require close coordination with the new FPC whose role it will be to manage the risks in the system as a whole.
• Secondly, in light of this objective there has been much debate about whether a regulator whose purpose is to promote financial stability could do so by focusing only on minimising the consequence of firm failures, rather than minimising the risk of individual firms failing in the first place. In a world without uncertainty it might well be justifiable to state that the regulator should not be obliged to seek to reduce the risk of firm failure. However in practice the inherent uncertainty and complexity of both firms and the overall system mean that this is not a realistic objective. The PRA will thus always seek to reduce the risk of individual firm failure but will give particular focus on ensuring that if failure occurs, it does so in an orderly manner. Furthermore, it needs to be recognised that international regulatory standards are explicit with regard to the need to maintain a baseline of supervisory oversight for major firms, with the intention of reducing the probability of failure.
• Thirdly, the obligation of baseline supervision should not detract from a key strand of the PRA’s approach, namely to ensure that the role of regulators is to complement and promote the disciplines of the marketplace, not to substitute for them. The presumption remains that the ultimate responsibility for managing a firm prudently rests with its management, board and shareholders.
• Finally, the consequence of this approach undoubtedly means that the PRA needs to recognise that if firms fail, society will rightly ask the question of whether that was a regulatory failure. However, failure of firms should be seen as a necessary element of a healthy, innovative system and thus the PRA should not be held accountable for all such failures. Particularly in those cases where the process of failure is an orderly one with minimal impact on the financial system or the firm’s customers.

Turning now to how the PRA will carry out its objective. As I have said before, a supervisor effectively has three types of tools.

• rules and regulations, primarily in the form of capital, liquidity, leverage and governance standards;
• resolution plans; and
• supervisory oversight of management actions and strategies, including recovery plans.

The reviews conducted by the FSA on the recent crisis, including the current one being carried out on RBS, demonstrate that the principal regulatory failure was the capital and liquidity rules which were completely inadequate. There is a view that the risk of firms failing could be eradicated altogether if there were sufficient capital and liquidity buffers. This is theoretically true, but the new capital and liquidity standards will not be set at such a level. This month has seen agreement in Basel on the G-SIB surcharge and thus we now know more about the amount of capital large banks will be required to hold. The Basel III framework will be a significant improvement on the historic position, but it will still require other risk mitigants to be in place.

At other end of the spectrum, it could be argued that so long as we could resolve all firms without material cost to the system, then we need neither capital nor supervisory oversight. This perfect world of resolution is not likely to be achieved. Indeed we are currently some years off being able to offer even reasonable confidence about being able to resolve a complex cross border group.

Given these realities, the PRA’s supervisory approach will be to deploy all three tools.

PRA supervisory approach

I turn now to how the PRA will deliver this supervisory approach. In order to make effective judgements, as I have said before, the PRA must equip itself with:

• high quality, experienced supervisors who are willing to make difficult judgements and command the respect of the firms they supervise;
• high quality analysis of the critical risks in relation to a firm’s soundness, notably: its business model, particularly in relation to risk and profitability, its capital model and its funding model;
• high quality analysis of the effectiveness of a firm’s governance model and the competency of its key executives;
• a clear understanding of the firm’s culture and the implications of that culture on its risk profile;
• a clear understanding of its recovery and resolution capability;
• a clear understanding of the consequence of the failure of that institution on the wider economic system; and
• a clear understanding of informed third parties’ views of the risks that a firm is running.

The PRA’s supervisory approach will be delivered by replacing the FSA’s ARROW process with a new simplified framework for assessing the risks posed by individual firms. This will enable supervisors to identify the core handful of issues which, in their judgement, management should be focusing on. It is of vital importance that our supervisors are able to distil these issues and judgements in a way that can be clearly communicated to a board of a firm.

The PRA’s supervisory assessment framework will capture three key elements:

• the potential impact on the financial system of a firm coming under stress or failing;
• the impact on the viability of a firm’s own business model of the overallexternal risk environment; and
• the firm’s overall safety and soundness.

The PRA will take a forward-looking and judgement-based approach to supervision. Beyond the baseline monitoring I mentioned earlier, the PRA will focus its resources on those firms and prudential issues that have the greatest impact on the stability of the UK financial system.

The PRA will introduce a new Proactive Intervention Framework, or ‘PIF’, with a set of stages, or triggers, that represent points at which regulatory intervention would be required. This is, in part, to formalise resolution arrangements but also to mitigate against the risk of regulatory forbearance. This will not detract from the judgment-based supervisory approach which lies at the core of the PRA philosophy. Supervisors will of course need to use their judgement within the PIF.

The PIF will set out both actions expected to be taken by a firm as its financial position deteriorates as well as the authorities’ actions to prepare for orderly failure or resolution of a firm. The PRA will adopt a high threshold of materiality when mitigating actions are raised with firms. Such actions will be closely linked to the PRA’s assessment of risks and focused on the stability of the UK financial system. In cases where a firm’s viability is under threat, the PRA will take supervisory action at an early stage to reduce the probability of disorderly failure.

The FCA’s objective

That is all I plan to say about the PRA’s operating model. Clearly the PRA is but one element of the future landscape and I will now make a brief comment on the FCA. On Monday this week we published a document outlining our current thinking on how the FCA will operate, and this was supplemented by a dedicated FCA conference yesterday.

The FCA will have responsibility over 27,000 firms. For 24,500 of them it will have both prudential and conduct of business responsibility. The key point for this audience, however, is that it will also have conduct responsibility for the firms falling under the PRA’s scope.

The government proposes to give the FCA a single strategic objective ‘to protect and enhance confidence in the UK financial system’. The FCA will deliver this through three operational objectives, which are:

• to facilitate efficiency and choice in the market for financial services;
• to secure an appropriate degree of protection for consumers; and
• to protect and enhance the integrity of the UK financial system.

In addition, there is a key obligation for the FCA to discharge its general functions in a way which promotes competition.

The FCA’s supervisory approach

It is clearly the government’s intention that in relation to its objectives the FCA will intervene in a more intrusive way, as well as earlier, than was the case for the FSA. To deliver on this intention the FCA will require new powers, particularly in relation to product intervention and financial promotions.

The main elements of the FCA’s supervisory approach will be to:

• deliver a forward-looking, judgement-based approach to regulation, at the core of which will be early intervention both in respect of products and selling processes;
• deliver meaningful choice and effective competition;
• deliver a credible deterrence agenda;
• deliver a more effective redress process;
• ensure consumers have the right information to make informed judgements; and
• act in a more transparent and accountable manner.

The supervisory model, as with the PRA, requires a new supervisory assessment framework to replace ARROW. This will include both firm-based assessments and comprehensive market, sectoral and product chain analysis. Central to its design, however, will be simplicity and a recognition that the approach must be understandable not just to regulatory specialists but to boards as a whole.

A word on the enhanced competition mandate which has already attracted comments and is a key feature of the proposed FCA remit. In the past the FSA understood that within the current regulatory framework competition matters were primarily for the OFT, and in particular that it should not use its powers in relation to fairness to intervene in respect of price. This is a simplification of our historic approach, but suffices for the purposes of my comments today, since the principal point I wish to make is that the new framework makes clear that government now expects the FCA to take a central role in the promotion of competition. The government is not expecting the FCA to become an economic regulator but is expecting it to utilise its powers to make judgements on pricing issues where they relate to fairness. Delivering on this mandate will require a step change relative to the FSA in the FCA’s technical skills and philosophy.

Other issues

That is all I intend to say about how both the FCA and PRA will carry out their activities. I do nevertheless encourage you to read our three publications which are designed to give you greater detail.

However, if the new regulatory architecture is to be successful it will not be enough just for the regulators to reform their own internal processes. To operate effectively, the PRA and FCA must engage with:

• the firms they regulate;
• other regulators both domestically and internationally;
• with the public; and
• those to whom they are accountable, notably Parliament.

On this topic I would just like to highlight three key issues.

• Firstly, coordination between the PRA, FCA and FPC. There needs to be a clear understanding about how the PRA and FCA will interact, particularly in relation to firm-specific supervisory decisions. It is also important to recognise that both the PRA and FCA need to engage closely with the FPC. This will be facilitated by their respective CEOs being on the Committee, but clear processes will need to be established to ensure relevant issues are escalated and discussed.
• Secondly, I have spoken about this many times but I cannot stress enough the importance of the changes to the European regulatory architecture. The PRA and FCA are now operating as an extension of a broader European policy-making framework. Therefore, effective engagement with the European process is paramount to their success. Critically, we need to win the argument in Europe that supervisors need to have firm-specific discretion and that regulations need to be tailored towards local circumstance. If this does not happen, the European framework will become discredited.
• Finally, a word on accountability. As I have said before, it is important that the new regulators are equipped to report on both their successes and failures to Parliament.

Conclusion

In conclusion, I hope my remarks today have given you a clear sense of how the PRA and FCA will operate. I hope it has also stimulated a debate to ensure that the approach is one that is fully understood and supported by society as a whole. However, the most important point I would like to make today is that change in regulation itself will not be sufficient to achieve the improvements which society deserves. This needs significant change in the approach taken by the firms gathered here today. A restoration of trust requires a visible step change by you – the banks. PPI was a missed opportunity to demonstrate your intent. I urge you to take the next one.

Many thanks for listening to me. I look forward to taking your questions.