New structure outlined by the Financial Services Bill abolishes the FSA and establishes ‘twin peaks’ model for prudential and conduct regulation.
The government has embarked on major reforms to the UK financial services regulatory structure, where responsibility for financial stability is currently shared by HM Treasury, the Bank of England (BoE), and the Financial Services Authority (FSA). Following the financial crisis of 2007/2008, this tripartite system faced criticism. The government intends to abolish this system, including the FSA, and establish three new regulatory bodies: the Financial Policy Committee (FPC), the Prudential Regulation Authority (a subsidiary of the BoE) (PRA), and the Financial Conduct Authority (FCA) (essentially a new name for the FSA). The Financial Services Bill (the Bill), which was published in draft form in June 2011, is the primary legislation containing the core provisions for the government’s proposed structure. The Bill contains extensive proposed amendments to the Financial Services and Markets Act 2000, the Banking Act 2009, and the Bank of England Act 1998. Transitional arrangements have already begun and the government has stated that it intends for the new structure to come into force in March 2013.
PRA and FCA
Institutions that manage significant risks on their balance sheet—banks, building societies, insurers, credit unions, Lloyds’s of London, and certain systematically important investment firms that have been so designated by the PRA (e.g., large broker-dealers)—will be dual-regulated by the PRA (for prudential purposes) and the FCA (for conduct purposes). This model of regulation has been dubbed ‘twin peaks’. The FCA will be the prudential and conduct regulator for all other financial services firms.
The PRA will have the general objective of ‘promoting the safety and soundness of PRA-authorised firms’ and will seek to ensure that those firms carry out their business without causing any adverse effect on the stability of the UK financial system. To achieve this objective, the PRA will be responsible for the authorisation, prudential regulation, and day-to-day supervision of dual-regulated firms, with the FCA responsible for regulating their conduct.
Types of firms that will be solely regulated by the FCA include personal investment firms, insurance and mortgage intermediaries, investment managers, custodians, and corporate finance companies. The FCA’s strategic objective is to ensure that the ‘relevant markets’ function well, those markets being the financial markets, the markets for financial services, and the markets for services that are provided by unauthorised persons in carrying on regulated activities without requiring to be authorised. Its operational objectives are to secure an appropriate degree of protection for consumers, to protect and enhance the integrity of the UK financial system, and to promote effective competition in the interests of consumers. The FCA will inherit the majority of the FSA’s existing roles and functions, with the exception of the responsibility for systemically important infrastructure, which will be transferred to the BoE. In particular, the FCA will be responsible for the conduct of business regulation of all firms (including dual-regulated firms), the prudential regulation of firms not regulated by the PRA, market conduct regulation, and acting as the UK Listing Authority. The FCA will also be responsible for regulatory oversight of client assets and for taking regulatory action to counter financial crime.
The explanatory notes to the Bill state that the FCA’s objectives are intended to provide a mandate for it to take action. The government intends for the FCA to have a more proactive, interventionist approach to conduct regulation than the FSA, with the aim that actual or potential risks will be addressed before they crystallise.
The FPC will be a committee of the Court of Directors of the BoE responsible for macroprudential regulation (as opposed to the PRA’s responsibility for microprudential regulation). The FPC’s objective will be to contribute to the BoE’s achievement of its financial stability objective under the Banking Act 2009 by identifying and monitoring systemic risks, and taking action to remove or reduce such risks. The government will legislate to give the FPC a ‘toolkit’ of macroprudential powers intended to address financial stability issues.
Transition to the New Regime
The FSA will remain the UK financial services regulator until the legislation has been implemented; however, transitional arrangements have already begun. The government has stated that it will be guided by four principles during the transition period: minimising uncertainty and transitional costs for firms; maintaining high-quality, focused regulation; balancing swift implementation with proper scrutiny and consultation; and providing as much clarity and certainty as possible for the staff of the FSA and the BoE. On 2 April 2012, the twin peaks model was introduced within the FSA as a shadow structure. The intention was to move the FSA as closely as possible to the new regulatory structure within the current legal framework by creating two new supervisory units—a prudential supervisory group with objectives aligned with those of the PRA and a conduct supervisory group with objectives aligned with those of the FCA. In a speech on 7 February 2012, Hector Sants, Chief Executive of the FSA, stated that for the new supervisory approach to work effectively, firms need to make behavioural changes. It was suggested that firms should avoid gratuitous regulatory arbitrage; be more willing to comply proactively with supervisory judgements; recognise that firms and regulators will inevitably make judgements which in hindsight are found to be wrong; and recognise that the new approach will require greater resources, expertise, and costs than the old reactive model. Mr. Sants emphasised that the move to a twin peaks model is an opportunity to drive home and further embed the move to forward-looking, proactive, judgement-based supervision, echoing the following comment by Sir Mervyn King, governor of the Bank of England: ‘The reason we want to move towards a twin peaks approach . . . is a question of judgement and culture, not structure’.
At legal cutover, the FSA Handbook will be split between the PRA and the FCA to form two new Handbooks expected to be published in draft form in early 2013. Dual-regulated firms will need to refer to both whilst FCA-regulated firms will only need to refer to the FCA Handbook.
Key Changes to the Supervisory Model Under the Twin Peaks Structure
The key operational change will be the discontinuation of the existing ARROW risk mitigation programme. Any outstanding actions will be split between those relevant to the conduct supervisory groups’ objectives and those that relate to the prudential supervisory group. From 2 April 2012, the two supervisor units began operating their own risk mitigation programmes, with firms having two separate sets of mitigating actions to address. However, pending legal cutover to the new regime, as Mr. Sants confirmed in his ‘Dear CEO’ letter dated 6 February 2012, the FSA will retain the current ARROW review cycle. Therefore, if a firm is due to complete an ARROW assessment before Spring 2013, it will still be subject to a supervisory review but one which will comprise two supervisory teams assessing the risks against their respective new objectives. Later this year, both the FSA and the BoE will publish two additional documents detailing how the PRA and the FCA supervisory regimes will function, and they will provide firms with a further opportunity to comment before those regimes go live.
Concerns for Firms
Prospective dual-regulated firms are concerned that having two regulators, each with its own agenda, will cause duplication. Although the intention is that the two regulators will work together and cooperate where necessary, there is still a risk of overlap and a divergence of agendas. The PRA and the FCA (and their shadow units) will make their own respective set of regulatory judgements against different objectives. Furthermore, this new judgement-based supervision implies a reduction in reliance on rules and an increased focus on the spirit of regulation. Firms will face more uncertainty no longer being able to rely on the fact that they are complying with the rules and thus avoid regulatory intervention. Additionally, as Mr. Sants noted, firms must recognise that the new approach will require greater resources, expertise, and costs than the old reactive model. Firms should consider taking a step back and looking at their whole business through the eyes of the new regulators to help them understand what changes they will need to make in order to comply with the new regime.
The Increasing Influence of Europe
In his speech, Mr. Sants acknowledged that, currently, in respect of prudential regulation in Europe and increasingly over the longer term in respect of conduct, the rules will be made by Europe—specifically, by the European Supervisory Authorities. The role of the PRA and the FCA will primarily be one of supervision and enforcement. Essentially, as Mr. Sants noted, the UK is moving to become a ‘supervisory arm’ of Europe. He also stressed that the UK will have to engage with the European regulatory process and that truly effective reform of the regulatory system will only be achieved if Europe delivers on the implementation of the Basel III framework. Reform will also depend on progress being made globally on the bank capital and liquidity agenda.
Current Status of the Bill
The Bill completed its stages in the House of Commons on 22 May 2012 and had its first and second readings in the House of Lords on 23 May and 11 June 2012, respectively. The next stage in the Parliamentary process is the Lords Committee stage which begins on 27 June. Royal Assent is expected to be given to the final version of the Bill by the end of 2012. The current expectation for the completion of the necessary primary legislation and the transfer of powers to the new regulatory bodies is March 2013.