On 8 July Treasury published the long-awaited White Paper on reforming financial markets. This follows the end of the consultation period for FSA’s Turner Review proposals in mid-June. The White Paper was itself followed later in July by three other important contributions to the debate on the future shape of UK financial regulation: The Walker Review of Corporate Governance in the Banking Industry, the Conservatives’ paper “From crisis to confidence: plan for sound banking” and the House of Commons Treasury Select Committee’s 14th report on Banking Crisis: Regulation and Supervision.

Rather than building on Turner’s proposals, the White Paper mainly supports them, assumes FSA will make the changes Turner suggests, and proposes ways to help FSA do so and to complement FSA’s role and powers.

The Tripartite system

The Government plans to keep the Tripartite system, but refine the roles of the three authorities. FSA’s powers in particular are to be strengthened. Lord Turner’s Review noted what had gone wrong with the Tripartite system, but avoided recommending changes. The Government believes the current institutional architecture is right, so changes should be focused on making it work better. It wants more powers for the Bank of England and especially FSA, better coordination between them, stronger governance, greater transparency, and a wider range of tools deployed to manage systemic risk.

In contrast, the Sassoon Report published last March for the Opposition Conservative Party found the Tripartite system fundamentally flawed and now the Conservatives’ White Paper, published on 20 July, sets out their plan to abolish it. George Osborne, the Shadow Chancellor, clearly does not support FSA. He would not only give macro- and micro-prudential supervision of credit institutions to the Bank of England but also supervision of other systemically important firms, including insurance companies. And he proposes to replace FSA by a new consumer protection regulator (the Consumer Protection Agency), which would also assume OFT’s powers of consumer credit regulation.

Council of Financial Stability

The Government White Paper seems to take on board the criticisms of operation of the Tripartite system made in the Sassoon report and elsewhere, particularly the poor of coordination. It proposes to legislate for a more formal and transparent structure, creating a Council for Financial Stability (CFS) comprising Treasury, FSA and the Bank and chaired by the Chancellor of the Exchequer. A statutory CFS seems a good idea, but the Government rejected independent membership, which had been powerfully advocated by DeAnne Julius, a former independent member of the former Monetary Policy Committee.

The Conservatives would make the Bank responsible for judging and controlling risks to the financial system as a whole. They will do this by creating a powerful new Financial Policy Committee within the Bank (but with independent external members), working alongside the Monetary Policy Committee. This would monitor systemic risks, use new macro-prudential regulatory tools and implement the special resolution regime for failing banks.  

Now the Treasury Select Committee has, broadly, sided with the Government. Although it, too, has been very critical of the Tripartite system, it believes that the problem was mainly the authorities’ judgements and decisions rather than the architecture. However, it also criticises the White Paper proposals as “largely cosmetic”: it wants a much clearer allocation of responsibilities.  

The right balance of regulation

The Government’s White Paper shows its support for FSA’s role and its work. It states categorically that having FSA as conduct of business and prudential regulator for all financial services firms is the right approach, leaving the Bank of England primarily responsible for financial stability. It rehearses the reasons for devolving all supervisory powers on FSA more than 10 years ago, and says global developments since then have only strengthened the case for the structure.  

But it acknowledges the Bank, too, needs more powers than it has had and should keep its role of being the independent body that assesses threats to financial stability.  

That said, Treasury plans a substantial extension of FSA’s powers, including:  

  • a new statutory objective for financial stability;  
  • powers to intervene in individual firms’ business in pursuit of that objective; and  
  • further enhancing FSA enforcement powers.  

Managing the problems of high impact firms

Apart from macro-prudential supervision, the tools of which have still to be elaborated, the White Paper focuses on four main ways to minimise the risk that a high impact – or systemically important – firm might fail and the impact if it does:  

  • stronger market discipline, through regulation of remuneration practices, and more effective corporate governance standards;  
  • better market infrastructure to reduce systemic risk and mitigate individual firm failure: greater standardisation and transparency for derivatives, and clearing OTC derivatives are key points;  
  • better regulation: not only substantive rules changes (particularly increased capital and liquidity resources, new leverage and other prudential requirements, and more stringent regulation of high impact firms) but also more effective supervisory, enforcement and monitoring tools, more tools and greater powers for FSA; and  
  • managing failure: beyond the resolution regime of the Banking Act 2009, the Government expects FSA to ensure that it becomes easier to deal with the failure of high impact firms. As a minimum, this means that firms’ legal structure facilitates resolution (for example, through subsidiarisation of overseas banks’ UK branches), and maintenance detailed and practical resolution plans or “living wills”.  

Some of these ideas, such as in clearing and remuneration, are also being addressed internationally - in the US and Europe, and in global fora - for example, by the Financial Stability Board (known until last April’s G20 as the Financial Stability Forum, so the British Government is not alone in rebranding stability bodies!). Others have nevertheless been widely discussed, and many have cross-party support - the “living will” for example. Strengthening corporate governance has been an FSA focus for some time and the controversial Walker Report puts more flesh on the bones of earlier proposals – though a review of Britain’s Combined Code, too, has been launched by the Financial Reporting Council.  

“Better regulation” means more intrusive and more expensive regulation, strongly enforced - relying more on bigger sticks (e.g. power to fine individuals who are performing controlled functions without approval) rather than carrots. Unattractive as it may appear to many, it may be better than some of the alternatives such as formal limits on size of financial firms, or requiring separation of retail banking from proprietary trading (or investment banking generally). Treasury explains in detail why it considers the Glass-Steagall model inappropriate.

FSA must surely recruit senior and experienced staff to achieve all this, beyond its Supervisory Enhancement Programme and other initiatives it is already undertaking.

The costs of enhanced supervision and the other measures will ultimately be borne by the industry: not only does it finance FSA’s budget but it will incur huge additional costs (staff, IT, professional fees, etc) and in repaying the Financial Services Compensation Scheme’s costs of rescuing Bradford & Bingley, Dunfermline Building Society and others. Not surprisingly the financial services sector has raised concerns about the impact of these costs on its international competitiveness, but Government and Parliament seem (even) less sympathetic to such arguments than they have been historically.  

More interventionist powers proposed for FSA

Although FSA already has significant powers to vary firms’ permissions (the scope of their licences) and take action against certain individuals, the Government plans to strengthen this to ensure FSA can use a range of powers in respect of any of its objectives. FSA will be better equipped to direct firms and intervene in their business, require information, monitor and supervise, investigate and enforce - against both firms and individuals.  

A collective redress mechanism

The White Paper proposes the development of collective redress mechanisms, which would reduce the costs in major areas of complaint to the Financial Ombudsman Scheme, for example on Payment Protection Insurance.  

What next?

FSA continues to implement its published annual plan, most of which was driven by responses to the financial crisis and tackles many of the issues which the crisis has raised. Much can be achieved without primary legislation.  

However, the Government has promised legislation this autumn, to create the CFS and increase FSA’s powers not only to deal with regulated firms, but also to get information from unregulated firms, even if outside the FSMA perimeter if necessary for macro-prudential and financial stability analysis – a potentially very intrusive measure. Although Government will wish to push through this legislation quickly, the law must clearly delimit these powers. In its zeal to address the problems, the Government should be careful not to impose measures that ride coach and horses through basic civil liberties. The devil will be in the detail of legislation - what checks and balances will be put in place? The Banking Act’s “Henry VIII provision” – giving the power to amend primary legislation by secondary legislation - makes for uncertainty and should not be repeated.  

Also in the autumn we shall see the final Walker Report, following responses to his July proposals.  

Whether or not the Government’s Bill is passed before a general election (due by June 2010), eyes will increasingly be focused on what will happen then. After the new Labour Government announced its reform of financial services regulation in 1997, it was more than four years before FSA regime came into effect. Depending who wins the election, a similar period of reform and institutional upheaval may lie ahead.