In June 2010, the Government announced its plan for the UK's system of financial regulation. HM Treasury set out its initial thinking in a July 2010 consultation, "A new approach to financial regulation: judgment, focus and stability". On 17 February 2011, HM Treasury published a second consultation "A new approach to financial regulation: building a stronger system", which sets out its more detailed thinking on these issues.

The new UK regulatory architecture

At the moment, the UK's banks, insurers and investment firms are authorised and regulated by the Financial Services Authority (FSA) - a single regulator that supervises them from a prudential and conduct of business perspective.

The Government proposes a "twin peaks" supervisory model, which separates prudential and conduct supervision. The twin peaks model will be operated through three new regulatory bodies: the Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).

The Financial Policy Committee

The Financial Policy Committee (FPC) will be:

  • Established within the Bank of England;
  • Responsible for the stability and resilience of the financial system as a whole; and
  • Able to make public pronouncements, and give public warnings, to raise awareness of issues, influence domestic and international opinion and (if necessary) draw attention to systemic risks and risk mis-pricing.

The FPC will also be able to:

  • Make recommendations to the PRA or FCA about financial stability issues - if it does, the PRA/FCA will have to comply with the recommendation or explain why it has not done so;
  • Give a direction to the PRA or FCA in certain narrowly defined circumstances. The direction will require the PRA/FCA to use their regulatory tools in a particular way and the PRA/FCA will be bound to do so.

The Government is also considering whether to give the FPC or PRA a range of other tools that could be used to set a maximum loan-to-value ratio on mortgage lending; impose "hair cuts" on repurchase agreements and over-the-counter derivatives; or set minimum requirements on the amount of collateral to be posted by an investor buying stock on credit.

The Prudential Regulation Authority

The PRA will:

  • Be a subsidiary of the Bank of England;
  • Be accountable to the Court of the Bank for administrative matters, including its budget and remuneration policy;
  • Have an overarching, strategic objective of "contributing to the promotion of the stability of the UK financial system";
  • Have an operational objective of "promoting the safety and soundness of PRA authorised persons" - an objective which "includes seeking, in relation to each PRA authorised person, to minimise any adverse effect that the failure of that person could be expected to have on the UK financial system";
  • Be required to have regard to a set of regulatory principles. These will include efficiency, proportionality, transparency, the principle that "senior managers (and not regulators) are ultimately responsible for managing their firms in a way that is compliant with the regulatory framework", and that "consumers should take responsibility for their decisions".

The PRA will regulate all UK banks and insurers. It will also be able to designate investment firms for PRA supervision if they pose a significant risk to the stability of the financial system or to a PRA regulated entity within their group. It is currently envisaged that designation will only apply to firms with permission to "deal in investments as principal", and that "BIPRU €730k firms[1]" , firms that are systemically important, and firms that are closely connected to a bank or insurer, will be capable of designation. Designation will be subject to prior consultation with the FCA and only occur after the firm has had an opportunity to object.

The PRA will be a judgment-led regulator that makes much greater use of principles than the FSA. It is expected to focus on the risks within each of the firms it regulates, how those firms will be resolved if they fail and the impact any failure will have on the financial system and public funds. Firms should expect the PRA to be rigorous and intrusive in its attempts to identify weaknesses and in its determination to require them to mitigate or resolve those weaknesses promptly.

The Government is still considering how to structure the PRA's decision-making and appeals processes. As the PRA's decisions will be judgement based, one possibility is that appeals will be heard by the Upper Tribunal and only permitted on grounds that could be raised on a Judicial Review. That is quite different to the full merits review currently available for FSA Supervisory decisions that engage the statutory notice procedure.

The Financial Conduct Authority

The FCA will:

  • Have an overarching, strategic objective of "protecting and enhancing confidence in the UK financial system"
  • Three operational objectives:
  1. "Facilitating efficiency and choice in the market for financial services";
  2. "Securing an appropriate degree of protection for consumers"; and
  3. "Protecting and enhancing the integrity of the UK financial system".
  • Be required to advance its operational objectives, where appropriate, by promoting competition; and
  • Share the PRA's regulatory principles.

The FCA will be responsible for the prudential regulation of about 18,500 firms. These will include independent financial advisors, insurance brokers, investment exchanges and investment firms that have not been designated for PRA regulation. It will also be responsible for the conduct regulation of banks, insurers and PRA designated investment firms.

From a prudential perspective, the FCA will be more concerned with preventing consumer detriment and damage to the reputation of the financial system if a firm fails, than with preventing the failure itself. For most firms, that will mean a minimum capital requirement that is enough to achieve an orderly wind down, and "base line monitoring" by the FCA. But "prudentially significant firms" (those whose failure could undermine an FCA objective) will be subject to more proactive and intensive prudential supervision.

On the conduct side, the FCA will seek to deliver different levels of protection for different types of consumer. The level applied will depend on the consumer's capability and circumstances, and the product and channel through which they are buying it. The FCA will take an entirely new approach to conduct regulation in the retail sphere. In particular, it will:

  • Have a lower risk appetite than the FSA, and be much more willing to take judgment based decisions;
  • Be much less prepared to see detriment occur, and so much more likely to intervene to prevent it by scrutinising product design and governance;
  • Act on actual or potential risk before it crystallises in significant consumer detriment, even if that means less choice for consumers and more uncertainty for firms.
  • To ensure these outcomes, the FCA will be able to:
  • Intervene to stop product launches and temporarily ban products or product features, with immediate effect;
  • Make rules that permanently ban products or product features, impose minimum requirements on products, or restrict their sale to certain classes of consumer;
  • Direct a firm to withdraw or amend a misleading financial promotion with immediate effect.

Like the PRA, the FCA will also be able to publish the fact that a product has been banned or a firm has been required to amend or revoke a financial promotion. This is a significant power that is expected to prevent consumer detriment and can only be wielded if the FCA complies with procedural safeguards designed to protect firms.

Approved persons

Individuals that exert significant influence over an authorised firm are required to obtain approval from the FSA before they can undertake these "controlled functions". The FSA has always regarded the approval process as an important consumer protection tool. But, since the financial crisis, it has broadened its "approved persons" regime and intensified its clearance processes. As a result, applications are much more likely to be rejected or withdrawn now than ever before.

Given the risks that inadequate management can pose to the soundness of regulated firms and to their customers, the new regulatory authorities will continue to conduct prior scrutiny of individuals carrying out controlled functions. For firms regulated:

  • Only by the FCA, the FCA will have full power to designate controlled functions and to approve individuals to undertake them;
  • By the FCA and the PRA:
    • Lead responsibility for controlled functions will be split between the PRA and FCA in line with their objectives;
    • Both authorities will be able to specify new controlled functions and approve or prohibit individuals from carrying them on;
    • The PRA will lead on designation and approvals of all controlled functions connected to the prudential soundness of a firm. And it will consult the FCA when it has an interest in a function, but the PRA will retain an approval veto;
    • The FCA will lead on all customer facing functions, consulting the PRA where it has an interest.

However, regardless of which authority leads on an approval application, both authorities will have the power to ban an approved person working in a dual-regulated firm.

In some respects, the Financial Services and Markets Act 2000 (FSMA) makes it difficult for the FSA to take regulatory action against individuals. The legal test for liability is tougher and the quality of the evidence must be better. Individuals can also have more at stake than firms, making them much more likely to defend regulatory action than to settle. Firms, and the approved persons they appoint, should expect the Government to use the transition to remove some of these obstacles, so that regulatory action against individuals will be easier in the future, and much more likely to be taken.

Practical issues

Developing the new regime

Although the Treasury's Consultation has given us a great deal more information about the new regulatory architecture than we had before, there are (quite reasonably) still many gaps to fill. The Treasury will begin to fill them when it publishes a draft bill in the spring. It hopes or expects that detailed Parliamentary scrutiny will follow and that its final Bill will receive Royal Assent in the summer of 2012. If it does, the new regulators will formally open for business in late 2012.

In the meantime:

  • The FSA and the Bank of England are working on the detailed operating models for the PRA and FCA, and further consultations will follow;
  • The FSA is beginning its transition into the new structure, with the aim of "road testing" key elements of the new regime before it goes live;
  • The Treasury is planning a series of round table discussions and seminars as a way of canvassing views on its proposals.

Although the structure of the new regulatory architecture may be a "done deal", the powers the Treasury proposes to give to the PRA and FCA are radical and could have far reaching consequences. Firms may therefore wish to submit a formal response to the Treasury's consultation now.

Implementing the new regime

Perhaps, surprisingly, the new legislative framework will be delivered by amending the FSMA, rather than by repealing and replacing it with two new Acts; one each for the PRA and the FCA. The Treasury argues that amending FSMA will be quicker, easier and therefore more cost effective than repeal and replace, but that seems unlikely. Amending one act will also make detailed consideration and response more costly and more complex than a simple repeal and replace would achieve. For those reasons, firms may wish to submit their consultation responses through a trade body or by instructing solicitors to prepare a response for a peer group on a common interest basis.

Costs and benefits

The potential benefits of the new regime are difficult to quantify - they depend on a mis-selling scandal, or a financial crisis, mitigated or avoided, where the cost and extent of the counter-factual is difficult to prove. The benefits of the new regime depend on the assumptions made about the frequency and severity of the disaster averted and the complexities of causation. But the costs of the new regime are reasonably clear: the cost of running and dealing with two regulators will be higher (and perhaps much higher) than the cost of running and dealing with one. Those costs will fall on firms and, eventually, on consumers.


In its consultation paper, the Treasury describes its reform programme as "a complex and weighty undertaking". It also explains that "it will be vital to get the detail of the legislation right, as well as the practical implementation". Even so, the Treasury has reduced the normal 12-week consultation period down to eight.

The FSA is working hard on the development of the new regime, and the transition to it. To achieve that outcome, it has increased its budget and diverted a good deal of existing resource. The FSA has also reduced its supervisory activity in some areas, and made it clear that it may take it longer to make regulatory decisions during the transition period. This brings opportunity cost for firms and regulatory risk for society as a whole. Those problems will be exacerbated by the speed and extent of the reform agenda and the uncertainty it creates for the FSA's already beleaguered staff.

Regulatory reticence

The success of the new regime will depend, in part, on the regulators' willingness to use their new powers, the extent to which the Government will be willing and able to protect them from the consequences of getting it wrong, and the procedural safeguards the Government creates for firms.

A decision to ban a product, or to force a firm to withdraw a financial promotion, that is followed by a public statement that the regulator has taken that action, could prevent significant consumer detriment. But it could also destroy a firm's business, and its employees' livelihoods, on a flawed premise.

The regulators will be aware of these difficulties, and they will quite properly be reluctant to use their powers without good cause (or at all). That reluctance might be overcome if the regulators are given an appropriate statutory immunity and firms have an appropriate opportunity to make representations before a decision is taken. Some complicated Human Rights issues will also have to be resolved before the process and regulatory immunity can be regarded as practical and fair, and before each individual decision is taken.

Regulatory tension

There is a curious tension between the FCA's objectives and its duties. For example, the Government describes competition as "an important new feature of the regulatory remit", which "goes significantly beyond the [provisions in] FSMA". It also states that "in addition to an operational objective which recognises the importance of efficiency and choice - two core characteristics of competitive markets - ...the legislation will place the FCA under a duty to advance its operational objectives, where appropriate, by promoting competition". But the Government also (reasonably) expects the FCA to secure an appropriate degree of protection for consumers, and has given it a power to intervene at an early stage in the product life cycle to make that protection "real". And it has done so knowing that "earlier regulatory intervention in the product life cycle could lead to less choice for retail customers and increase uncertainty for industry". It is also likely to increase firms' product development costs and reduce innovation.

For these reasons, there is still a long way to go and, from a firm and consumer perspective, there is "everything to play for". Firms and consumer bodies should submit their responses to this consultation now.