The UK’s new regulatory structure
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...
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.