Regulating financial services in the UK
Speech by Callum McCarthy, Chairman, FSA
at the BBA International Banking Conference
10 June 2008
This is a particularly good time to take stock of the regulatory regime for financial services in the UK. The turbulence in financial markets – what the ECB’s President Trichet accurately describes as “the ongoing reappraisal of risk in financial markets” – has led to a review round the world of regulatory policies and practices.
In the US, the President’s Working Group has proposed quite fundamental changes to the fragmented pattern of US regulation; in Europe, a group of European wise men have – predictably – called for a single European regulator of financial services; and in the UK the problems which had long been recognised of gaps in the UK legal and regulatory arrangements for how to deal with a failing bank, and which were being addressed before the present problems in finance crystallised, are being tackled by the establishment of new legislation to be introduced later this year, which was described in a consultation paper published by the Tripartite Authorities in January, and where a further consultation paper will be published this month.
As well as these various proposals to make structural changes to the regulatory framework, there are a wide variety of more detailed proposals to address financial instability, which have very effectively been summarised in the report of the Financial Stability Forum presented by Governor Draghi to G7 Finance Ministers in Washington in April: follow up on this report will involve work not only by individual national supervisors, but also by a range of international organisations – the Basel Committee, IOSCO, the Joint Forum, the IASB, the three Lamfalussy Committees within Europe – as well as – crucially – by the board and management of financial firms.
Some of these proposals reflect long-running discussions: there is nothing new about argument over the structure of European regulation for financial services, nor about the debate on fair value accounting, nor about the consideration of what should follow the introduction of Basel 2. But all these have been given a new urgency by the scale, severity and duration of the effects of the ongoing reappraisal of risk which we are experiencing – and, it should be recognised, by a series of regulatory failures which have occurred: I do not believe that those regulators concerned, whether central banks or separate supervisors, will wish to argue that their performance in relation to the supervision of mortgage origination in the US, or of individual landesbanks in Germany, or of Northern Rock in the UK, has reached the standards they aspire to. You know that the FSA has very publicly (and determinedly) set out our analysis of the FSA’s performance in supervising Northern Rock in the run up to its crisis, and what we will do to improve. We are unique in setting out openly this analysis of our performance. I do not believe we are unique in requiring such analysis to be performed.
Against this background of widespread discussion of the structure and practice of regulation, I want this morning to consider what changes I believe should be made in the UK – and, at least as important, what should be maintained.
It is critical that, in responding to the present pressures for change, we are conscious both of the danger of inappropriate responses – what I will loosely describe as the Sarbanes-Oxley response to Enron, though there are a depressing number of comparable examples – and of the advantages which the present arrangements have brought to the UK. I would simply remind you that a series of US reports have identified the principles which inform UK regulation as conferring substantial advantages to the UK. The Bloomberg:Schumer report, for example, said: “Respondents to the CEO survey … ranked attractiveness of the regulatory environment as the single most important issue determining the international competitiveness of a financial market. Business leaders increasingly see the UK’s regulatory model as better suited [than that in the US] to a global financial centre …”.
The principles which have underpinned the regulatory framework in the UK for the last decade remain good principles, which we would depart from at our peril and to our cost. The principles which informed the structure of regulation were the need to avoid duplication between the roles assigned to each of the Tripartite Authorities (FSA, Bank of England and Treasury); to achieve clarity of responsibility and of decision making; and to have a structure flexible enough to respond to an increasingly complex, increasingly global and increasingly integrated financial services marketplace. The principles which inform the practice of regulation are a risk‑based approach, based on a balance between general principles and specific rules.
The structural principles remain as valid today as when they were promulgated in 1997. I attach particular importance to the avoidance of duplication and to clarity of decision making: banks should know who they should talk to about a particular issue, and should have to speak to only one supervisory authority about that issue. The events of the last ten months have served to reinforce rather than detract from the importance of this principle. And – as a concomitant of this clarity – there is an obligation on the authorities to share information fully and promptly among themselves to the extent that their respective responsibilities require this. In practice, this is happening: since the present liquidity issues crystallised in August last year there have been frequent meetings of the Tripartite Authorities to pool information and intelligence about market developments. One of the items I read daily is the early morning Bank of England report on market developments, where the Bank’s normal market contacts are an invaluable source of information, supplementing the information the FSA obtains, via different contacts, from particular firms and institutions.
I am also continually reminded of the great benefit the UK derives from the single nature of regulation and supervision, embracing both conduct of business and prudential issues. Again, recent events have demonstrated the interlinkage between these two strands of regulation; and covering financial institutions irrespective of whether the firm is an asset manager (including, I would observe, hedge fund manager), bank, broker-dealer, insurance company or building society. In a world where a transaction entered into by a bank, a security firm or an insurance company can have the same economic impact, I see great disadvantage in supervision organised on sectoral grounds – ie split between banks, securities houses and insurance firms – both in terms of danger of regulatory arbitrage and inconsistency; and in terms of the cost – financial and managerial – of subjecting a complex financial organisation to multiple regulators. I know from conversations with both policy makers and practitioners in the US how keenly they feel that the UK system, in this respect at least, provides a model to be emulated.
In terms of regulatory practice, as distinct from regulatory structure, I continue to see great benefit from the adoption of a risk‑based approach, and from the use of principles as well as detailed rules. Those are sometimes represented – quite incorrectly – as somehow being what is characterised as a “light touch” (or, even more misleadingly, “soft touch”) regime. There is nothing light or soft about the use of principles. Indeed, I would remind anyone so misguided as to believe that principles are less demanding than rules that principles confer flexibility on the regulator. There are numerous examples where the FSA has been able to take enforcement action against a firm or individual for a breach of a principle, even when no specific rule has been broken. In 2005, for example, the FSA fined Citigroup £13.9 million for breaching FSA principles 2 and 3 (by failing to conduct its business with due skill, care and diligence, and failing to control its business effectively), in respect of the now notorious MTS trade. Although that trade affected markets adversely in many EU markets, the sole EU regulator able to take enforcement action was the FSA, something which owed much to our ability to act against a breach of principle.
I have set out principles both of regulatory structure and of regulatory practice which I believe have served us well, and should be maintained. The principles outlined above remain valid. Recent events have demonstrated however that changes need to be made to improve the way in which these are translated into practice. Let me turn to some of the changes which I believe we should make. There are four which I believe are of particular importance.
FSA execution
I should start at home: those things which we at the FSA need to do to improve the execution in practice of principles of whose validity and value we remain convinced. We have set out an analysis in respect of Northern Rock – an analysis which no-one has accused of failing in candour or clarity – of how the FSA’s execution of our supervisory standards fell short of our own standards. In response, the executive team has proposed and the board has agreed a programme to correct these inadequacies. This involves a sharper focus in our supervision of banks on prudential issues, particularly liquidity; a greater emphasis in our risk approach towards high impact firms; a strengthening of our risk analysis capability; and an increase in our supervisory resources, including at senior adviser level. This – the supervisory enhancement programme – is now launched, with changes already made, including the recruitment of Colin Lawrence as the director to run the Prudential Risk Division, and of Naguib Kheraj, former Finance Director of Barclays, as senior adviser to the programme.
Resolution Framework
Of much wider impact is the legislation, to be introduced this October but described in January’s consultation paper. The proposals described there represent the most significant change in the UK’s regulatory regime for banks for at least a decade. They will shape the attractiveness of the UK as a banking centre for decades. The critical elements of the proposal are:
- an explicit legal recognition of what is already one of the Bank of England’s core responsibilities, that of financial stability, and changes to the oversight of this responsibility by the Court;
- a range of measures designed to improve the supervision of financial institutions, to make failures less likely;
- the introduction of a resolution regime to deal with failing banks;
- changes to the compensation scheme, to make it easier and faster to pay off depositors in the event of failure;
- measures to build on and improve the co-ordination of the Tripartite Authorities.
These are designed to improve, not radically change, the existing framework of regulation. The principles set out in 1997 which I described earlier remain good principles. The Government has made clear that they should be maintained.
I think it helpful to set out how we envisage the improved arrangements working for any bank against three sets of circumstances: first, normal conditions; second, when a bank is running into difficulties – what we call heightened supervision; and third, if necessary, when the resolution regime is actually invoked.
In normal circumstances, supervision will remain, as now, with the FSA. As now, the Bank of England will be able to access information collected from banks by the FSA as part of its integrated regulatory reporting programme. We will want to ensure that the views of both the Bank and HM Treasury are taken into account in defining what information is normally collected (bearing in mind that, under FSMA, the collection of data must be justified on cost:benefit grounds). The Bank may also require information for the purposes of specific exercises which we would hope to be able to meet from existing information. If this proves inadequate, I see advantage in the FSA collecting additional information, so that banks face only one information-gathering authority. Normal supervisory visits and discussions will rest with the FSA. I think that there may be occasions – when discussing thematic work, for example – when it would make sense for a Bank colleague to join the FSA team on a visit.
For a bank that becomes subject to heightened supervision, there will be a need, for so long as the Bank of England remains the source of liquidity assistance, for it to be able to assure itself that it fully understands the troubled institution’s position. I therefore envisage the Bank might have discussions directly with the troubled institution, focused particularly on eligible collateral, treasury practices and other factors affecting the policy and practicalities of providing liquidity support. And during the period of heightened supervision, there will obviously be a very close sharing with the Bank and HM Treasury, and the Financial Services Compensation Scheme, of information collected by the FSA and judgements made by the FSA about the troubled bank.
The question of movement from heightened supervision to the resolution regime is clearly of central importance – legally, and practically. Central to that decision is a judgement about whether the troubled bank continues to meet and has the prospect of continuing to meet its threshold conditions, including the requirement to maintain adequate financial resources including liquidity and capital requirements. I regard that judgement as inseparable from the normal task of supervision, which involves constant assessment of threshold conditions, and therefore a judgement which should be made by the FSA, and solely by the FSA. Any alternative would breach the principles of clarity of responsibility and avoidance of duplication which have served us so well – and would lead to confusion and additional burdens for the management of the troubled bank. Furthermore, this judgement as to threshold conditions is at the heart of a supervisor role. To weaken the supervisor’s authority in this respect by giving someone else a parallel power would be to place the FSA in a position of responsibility without authority – never a sustainable position. I am glad that the BBA has concluded that this task properly should remain with the FSA. We would, of course, as part of the close communication which is a feature of heightened supervision, share our information and judgements with both Bank of England and HM Treasury.
Finally, there is the question of how the resolution regime will operate. Whoever is chosen to run a bank once it enters into the regime, it should not be the FSA: it is unreasonable to expect a single institution both to regulate and to run a bank, and FSA’s role should be confined to that of regulation alone – as it is presently in relation to Northern Rock.
There are other aspects of the legislation which, although important, I will not attempt to cover – other than to repeat my assessment that this is a legislative and regulatory initiative of profound importance to the banking sector. Getting the policy right is paramount.
Compensation
The third area of work I would identify relates to the incentive structure within financial services firms. The present bonus system places excessive emphasis on the short term performance of individual parts of an organisation; and it encourages the taking of trading positions whose immediate profitability (often unrealised but marked to market) is rewarded, but whose accompanying risk is neither properly recognised, nor disincentivised. This is a problem which has long been faced in traditional banking in respect of credit, where the immediate income on arranging a loan is offset by the provisions which inevitably attach to advancing loans. We need to have comparable incentives – and disincentives – on the market side. I think it entirely appropriate for supervisors, as part of our general assessment of systems and controls, to be interested in compensation and incentive structures, and – just as we take other aspects of a bank’s control philosophy and practice into account – to adjust our assessment of prudential requirements, including capital, for a bank accordingly. Please note that I am referring to incentive structures. We have no part to play in assessing or influencing individual bonuses or individual remuneration.
I do not claim this will be easy. But it is something to pursue both in the UK and internationally, where I hope the Joint Forum will address these issues.
Liquidity
The fourth initiative I would stress is liquidity supervision. Supervisors round the world need to pay more attention to, and overhaul, our liquidity regimes. The present troubles started with liquidity pressures, and evidently the present liquidity regimes are not up to the demands put upon them. That is why the FSA in December set out for consultation a series of measures designed to improve the UK's liquidity regime, on which we last month published an update. I know that international banks would like to manage their liquidity globally, subject to one global, not several national, set of rules. But, unless there is a step change in the speed with which the Basel Committee progresses international agreement, regulators will be forced to deal with this on a national level. That is what we plan to do in the UK. I am of course very keen that the Basel Committee should actively consider whether it can develop a resilient approach to the cross-border management of liquidity for banking groups, which meets the most compelling requirements of regulators and industry alike. But we cannot delay.
Firms in our view need to have a clear assessment of the liquidity risks that they are running and an acute awareness of the circumstances that would cause them to seek emergency liquidity assistance from the central bank. Authorities need to have sight of these plans and take a view as to whether the firm is or is not posing an unacceptable call on what is ultimately the taxpayers' money. If there is a threat that the bank will too readily call upon the central bank for emergency liquidity assistance, the authorities should be in the position to order the bank to curtail its liquidity risk, either by adjusting its positions or increasing the stock of liquid assets that the bank holds. Banks should have recourse to emergency liquidity assistance only in exceptional circumstances that are beyond their control, and banks that are unable to repay such assistance fairly quickly should recognise that they run the risk of being pushed into the resolution regime.
Let me sum up. The principles which determine both the structure and the practice of regulation in the UK remain sound, but we need to change, develop and improve how we translate these principles into practice. I have described four important changes which the authorities plan to make. You will note I have not discussed the changes banks themselves should consider – a wide, important but different set of issues.