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Financial regulation: A new approach

03 August 2010

On 26 July 2010, HM Treasury published a consultation paper building on Chancellor George Osborne's Mansion House speech in which he outlined his proposals to re-shape financial regulation in the UK.

In the consultation paper, the Treasury reiterated that there had been significant failings in the UK regulatory framework and that regulators failed to recognise and respond to problems that were emerging in the regulatory system.

Regardless of the fact that very few countries operate a twin peaks model of separating out prudential and conduct of business regulation, the Government feels that prudential and conduct of business regulation requires different approaches to regulation, and that combining them in the same organisation is difficult. 

The Government will therefore replace the existing ‘tripartite’ system of the Financial Services Authority (FSA), Bank of England (the Bank), and the Treasury, which has collective responsibility for financial stability, with a system that places the Bank at the heart of financial regulation. It also proposes to create a new regulator responsible for conduct and business regulation, which for the time being is referred to as the Consumer Protection and Market Agency (CPMA).

Macro-prudential regulation

Under the current regulatory system, the Government contends that insufficient attention was paid to the systemic or aggregate risks that built up in the financial sector. Macro-prudential regulation aims to address this problem by looking at the financial system as a whole, rather than at individual firms in isolation.

The Government will therefore put the Bank in charge of macro-prudential regulation through the creation of the Financial Policy Committee (FPC) within the Bank. It will be the FPC’s role to identify imbalances, risks and vulnerabilities within the financial system and take action to mitigate these in order to protect the wider economy.

Since the implementation of the Banking Act 2009, the Bank has had a statutory objective to ‘contribute’ to protecting and enhancing the stability of the UK’s financial systems. The Government will review this objective as a result of the proposals to place the Bank at the centre of the framework for preserving financial stability. Within the Bank’s overall financial stability remit, the objective of the FPC will be to protect financial stability by:

The Government will also consider whether, in addition to its primary objective, the FPC should be mindful of other secondary factors when considering a course of action.

In order to enable the FPC to fulfil its macro-prudential remit, the Government intends to provide the FPC with a number of specific tools. For example, in order to try to increase the resilience of the financial system to cyclical developments, possible levers that might be used could include:

The PRA

Coupled with the Bank’s new macro-prudential supervision role, the Government will transfer operational responsibility for the prudential regulation of certain firms currently regulated by the FSA to a new subsidiary of the Bank called the Prudential Regulatory Authority (PRA), which, as well as being the micro-prudential regulator, will be the key implementer of macro-prudential policy. 

The PRA will be responsible for the authorisation, regulation and day-to-day supervision of firms who are currently subject to ‘significant’ prudential regulation. The regulated activities and categories of firm the Government expects the PRA to cover include:

Unlike the FSA, which has four statutory objectives under section 2 of the Financial Services and Market Act 2000 (FSMA), the PRA will have one primary objective namely to promote the stable and prudent operation of the financial system through the effective regulation of financial firms, in a way which minimises the disruption caused by any firms which fail. 

Like the FSA, the PRA must ‘have regard’ to a statutory range of factors in the carrying out of its functions in pursuit of its primary objective. The Government is consulting on the factors to which the PRA must have regard and considers such factors to fall within three categories.

First, the objectives of other regulatory authorities (for example the FPC and the CPOA) must be considered. 

Second, principals of good regulation must also be considered. The Government does not believe that all of the principals of good regulation that apply to the FSA under section 2(3) of FSMA should necessarily apply to the PRA. For example, the Government is not convinced that a regulator charged with ensuring the safety and soundness of risk-taking firms should have regard to global competitiveness and innovation. 

Third, there should be other considerations that the PRA has regard to in order to ensure that the PRA’s pursuit of its primary objective is balanced against, or is pursued in accordance with, important matters which relate to the public interest. 

The Consumer Protection and Markets Authority

Regulation of both retail and market conduct within the financial system will be carried out by the CPMA, although the name for this authority is not yet set in stone.

It will be independent of Government and it is possible that it will adopt the legal corporate identity of the FSA.

The CPMA will regulate:

The CPMA will also be solely responsible for the authorisation and supervision of all financial institutions not regulated prudentially by the PRA and will also write the prudential regulatory framework for those firms.

Like the PRA, the CPMA will have a single primary objective. The primary objective of the CPMA will be to ensure confidence in financial services and markets, with particular focus on protecting consumers and ensuring market integrity. The factors that the CPMA must have regard to are couched in similar terms to the ‘have regards’ of the PRA. With regard to the factors linked to the public interest, the Treasury’s consultation paper states that such factors could include:

The CPMA will also take on the FSA’s existing responsibility for the Financial Ombudsman Service (FOS) and will oversee the Consumer Financial Education Body (CFEB), the role of which is to improve financial capability. The CPMA will also have responsibility for the Financial Services Compensation Scheme (FSCS) but, given the important role it plays in financial stability, it will work closely with the PRA in this regard. 

PRA and CPMA: Powers and functions

The Government will legislate to divide the powers and functions set out in FSMA into separate stand-alone prudential and conduct regulation frameworks. In some cases, it may be appropriate for powers and functions to be transferred exclusively to either the PRA or the CPMA; in other cases there may be a need for overlapping powers and functions.

The Government will consult on draft legislation to provide the necessary powers and functions to the PRA and CPMA. 

The key functions of the PRA will include:

The CPMA will have the following powers and functions:

Market conduct

A markets division within CPMA will regulate all aspects of the conduct of participants in wholesale markets (whether through organised financial markets or over the counter dealings). This will be in addition to it taking over the FSA’s responsibility for conduct of business regulation and the supervision of all consumer facing FSA regulated firms, as well as oversight of the FOS, the CFEB and the FSCS.

The CPMA will also regulate various elements of market infrastructure, such as investment exchanges and other trading platform providers. However it is likely that the Bank will be responsible for overseeing central counterparty clearing houses and settlement systems alongside its existing responsibilities for payment systems oversight. 

Consumer credit

The Government also feels that the creation of the CPMA as a strong consumer voice presents an ideal opportunity to look again at the manner in which consumer credit is regulated. The Government therefore intends to consult on the merits of a transfer of responsibility for consumer credit from the OFT to the new CPMA.

This consultation, to be published jointly by the Treasury and the Department of Business, Innovation and Skills in the autumn of 2010, will consider how the extensive legislative framework underpinning consumer credit regulation might be simplified and whether it should be brought under a single regulatory regime. It is therefore conceivable that the Consumer Credit Act 1974 will be repealed in its current form.

Implementation

The timetable for the implementation of the new regime is tight, as the Government would like the new system to be in place by 2012 (although no specific timetable has been determined) and it is proposed that early next year a further consultation paper will be published which will include draft legislation and core parts of the proposed Bill required to implement the changes.

In order to ensure that FSA staff and regulated firms are prepared for the transition to this new regulatory structure, it will be essential to implement non-statutory changes to the internal structure of the FSA in advance of the legislation coming in to force.

However, any work on transferring consumer credit may progress on a longer timetable than the regulatory reform work set out in the consultation paper. 

Conclusion

Other than the implementation of the new macro-prudential supervisory framework, the rest of the proposals set out in the consultation paper look suspiciously like an expensive re-shuffling of the pack, with the CPMA looking like the current FSA minus prudential regulation of credit and insurance institutions and market makers, which will be regulated by the PRA.

However, by splitting the FSA, those currently employed by the FSA will not have as much opportunity to make internal transfers and will need to become more specialised in a given area. As the Treasury states in the consultation paper, by giving the PRA a clear focus on prudential regulation, its supervisors will have the opportunity to develop a greater expertise in this area.

The consultation paper is also silent as to how firms will become authorised by the respective regulators. Whether they are required to apply for authorisation or are grandfathered over to the new regulatory authorities remains to be seen.

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Paul Estlin

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