As foreshadowed in the PRA’s approach documents, the PRA intends to rewrite its existing Handbook into a more concise statement of its rules. This new ‘Rulebook’ will look very different from the existing Handbook, which is largely inherited from the Financial Services Authority (FSA). It will contain a new set of ‘Fundamental Rules’ which will replace the existing Principles and will not contain any guidance. This will mean firms will have to rely on their own judgement as to how they are required to comply with the all the rules. These changes could have significant implications for all PRA-authorised firms, including insurers.
In this newsletter, we explore the PRA’s latest proposals in this regard as set out in its consultation paper (CP 2/14) published in January 2014.
Concerns raised in the context of an earlier consultation and the PRA’s response
In a previous consultation paper (CP8/13), the PRA set out its high level proposals to move material contained in its current Handbook into a new form and structure containing rules (and, where relevant, directions) only. To reflect this change, the Handbook would be renamed the ‘Rulebook’. While the PRA reports that respondents to its previous consultation paper were broadly supportive of these proposals, concerns were raised about the removal of guidance from the Rulebook.
In the current consultation, the PRA makes clear that, while the Rulebook will not contain guidance, the PRA will not cease to provide any form of guidance to firms. It undertakes to provide ‘Supervisory statements’ to explain clearly and concisely the PRA’s expectations where it is not possible to make rules that fulfil this function. The reluctance to include guidance in the Rulebook may stem from a desire by the PRA to avoid creating unintentional safeharbours from the rules that firms could seek to exploit. It remains to be seen whether the PRA will succeed in producing Supervisory Statements that avoid this result.
The PRA has previously announced its intention to split the Rulebook into rules which apply to the banking and insurance sectors, with a further split into directive and non-directive firms. The PRA believes that this should help firms to determine whether a particular rule applies to a specific activity but the PRA does not intend to develop a facility to assist firms to make this determination. We hope that the structure of the Rulebook will permit firms to reach a decision about the application of a particular rule as this may not always be evident (e.g. would a rule focused on insurers apply to the non-insurance activities undertaken by an insurer).
Proposed amendments to the Principles for Businesses – the Fundamental Rules
The most significant new proposal outlined in the current consultation is the PRA’s intention to replace the Principles inherited from the FSA with the Fundamental Rules. Broadly, the Fundamental Rules will apply to all PRA-authorised firms, regardless of their size or the sector in which they operate.
The consultation paper emphasises that the Fundamental Rules, along with the PRA’s approach documents and the Threshold Conditions, will be central to the PRA’s supervisory approach and will inform the structure of the remainder of the Rulebook. The Fundamental Rules have been drafted to be an expression of the PRA’s general objective of promoting the safety and soundness of the firms it supervises and thus respond to a recommendation from the Parliamentary Committee for Banking Standards (PCBS) that the Principles be amended to include safety and soundness.
As with the Principles, the Fundamental Rules are intended to apply at all times and will apply in areas where no other PRA rule exists. Consistent with its emphasis on a firm taking responsibility for its own decisions, the PRA believes that the Fundamental Rules leave scope for firms ‘to achieve compliance in a way they consider adequate.’ However, should the PRA consider the firm’s compliance to be inadequate or the firm to be in breach of the requirements, the PRA will take enforcement action, even in cases where no underlying detailed rule exists.
Contents of the Fundamental Rules
The PRA intends for there to be nine Fundamental Rules. Several of these are variations of existing Principles but with amendments to broaden their scope. For example, the first Fundamental Rule provides that ‘A firm must act with integrity’. Principle 1 currently states ‘A firm must conduct its business with integrity’. According to the PRA, the replacement of ‘conduct its business’ with ‘act’ reflects the desire to capture all behaviour that could affect a firm (including when it makes business-related decisions).
There are a number of Fundamental Rules that are entirely new. Fundamental Rule 3, for example, provides that ‘A firm must act in a prudent manner’. Again, on its face, this is potentially an extremely wide ranging rule. In the consultation paper, the PRA clarifies that this will not prevent a firm from entering into speculative investments where such activity is part of its business. However, a firm will be expected to take due account of all risks and possible consequences for it (and its group) before entering into such arrangements. Extending this principle further, the consultation paper states ‘The FR [Fundamental Rule] requires the firm not only to evaluate risks it exposes itself to, but also risk to which it exposes others in the financial system, before taking a course of action.’
It will be interesting to see how the PRA interprets this rule in practice and what, if any, certainty firms can hope to receive in advance of its application. It may not be obvious to the firm that an advantageous or profitable agreement it has struck with a counterparty could contribute to an unacceptable deterioration in that counterparty’s safety or soundness. Will action that a firm takes to protect itself (for example, by closing-out positions that are in the money when it fears that a counterparty may be in distress) fall within the scope of this rule? In assessing compliance with this rule, we would hope that the PRA will consider the information known to the firm at the time rather than assess the firm’s actions with the benefit of hindsight.
Fundamental Rule 8, which states ‘A firm must prepare for resolution so, if the need arises, it can be resolved in an orderly manner with a minimum disruption of critical services’, is also new and reflects the importance the PRA places on a firm’s resolvability.
While the PRA acknowledges that there is currently no special resolution regime for insurers in the UK, it still expects insurers to provide all information needed for the PRA to perform an assessment of their resolvability. Where significant barriers to resolvability are identified, the PRA expects firms to implement changes to reduce these where possible. The PRA expects a resolution regime to be introduced in future for systemically important insurers. Accordingly, such firms should prepare for resolution not only the basis of existing rules but also with an eye to any proposals for future resolution regime which may be introduced.
It is difficult at this stage to assess the effect this rule will have on the PRA’s supervision of insurers. Again, much will depend on how the PRA interprets this rule in practice. It has the potential to be onerous, particularly for those firms that may not be subject to a formal resolution regime in the future.
Another new Fundamental Rule provides that ‘A firm must not knowingly or recklessly give the PRA information that is false or misleading in a material particular’. The PRA states that this is intended to emphasise the importance of the quality of information the PRA receives, regardless of the form or type of that information.
The rule contains similar wording to the criminal offence found at section 398 of the Financial Services and Markets Act 2000 (FSMA) but is not limited to information provided pursuant to a regulatory requirement. In the PRA’s view, the drafting of the rule allows information to be submitted on a ‘best endeavours’ basis since there is no obligation to ensure accuracy. It is debateable whether this is the correct approach since a failure to use ‘best endeavours’ should not automatically equate to ‘knowing’ or ‘reckless’. The words ‘material particular’ emphasise that the PRA expects reasonable accuracy and completeness of information.
This rule would allow the PRA to take enforcement action against a firm where it is reckless as to the accuracy of the information it provides. This will reinforce the care firms need to take when responding to requests for information from the PRA. A deliberate failure to disclose something that the PRA considers material would likely breach this Fundamental Rule as well as Fundamental Rule 7. There is in any event the potential for tension between the requirements for accuracy and completeness of information under this Fundamental Rule and the obligation, under Fundamental Rule 7, for firms to deal with regulators in a ‘timely way’.
The proposed Fundamental Rules:
- A firm must act with integrity;
- A firm must act with due skill, care and diligence;
- A firm must act in a prudent manner;
- A firm must at all times maintain adequate financial resources;
- A firm must have in place sound and effective risk strategies and risk management systems;
- A firm must organise and control its affairs responsibly and effectively;
- A firm must deal with its regulators in an open, co-operative and timely way and must appropriately disclose to the PRA anything relating to the firm of which the PRA would reasonably expect notice;
- A firm must prepare for resolution so, if the need arises, it can be resolved in an orderly manner with a minimum disruption of critical services; and
- A firm must not knowingly or recklessly give the PRA information that is false or misleading in a material particular.
Proposed amendments to the body of the Handbook
The PRA intends to introduce the following new parts into the Rulebook: (i) Information Gathering (replacing SUP 2); (ii) Auditors (replacing SUP 3); (iii) Use of Skilled Persons (replacing SUP 5); and (iv) Permissions and Waivers (replacing SUP 6 and SUP 8). We do not propose to cover these changes here but may do so in a future newsletter.
The changes to the Principles in the form of the new Fundamental Rules reflect the PRA's desire to move towards a more judgment-based style of supervision. It is clear from the proposals that the PRA expects judgement to be exercised by firms as well as by the regulator.
While the underlying philosophy behind this shift is to be welcomed, it is to be hoped that the PRA will provide more detail on what it will expect of firms and how it will interpret the Fundamental Rules in practice, since it will be the final arbiter of whether any particular judgment was sound and in compliance with the rules. For example, what may be prudent behaviour in the eyes of a regulator might be regarded as excessively cautious from the perspective of an insurance executive.