It has been hard to keep track of regulatory outpourings of the last few weeks, let alone months. Official and unofficial reports, consultations and pronouncements have come from all over the world. In the middle of it all, on 1 April, Thomas Huertas, Director, Banking Sector at FSA, gave a speech on the future of banking regulation. This article looks at the possibilities for the future regulatory landscape for banks.

What went before?

Huertas spoke at the inaugural conference of the International Centre for Financial Regulation at the beginning of April. During February and March, there had been important papers from the EU and FSA which considered failures in banking regulation and suggested future improvements.  

Specifically, the de Larosiere group reported in February for the European Commission. Among the issues it singled out were:  

  • differences between regulation and supervision and failings in each – inappropriate regulation, weak supervision and poor macro-prudential oversight;  
  • reform of the Basel framework in respect of capital (including the need to reduce pro-cyclicality and introduce stricter rules for off-balance sheet items), liquidity and reliance on external ratings;  
  • risk management and internal controls; and  
  • failures in cross-border supervision and co-operation. Lord Turner in his March Review on a regulatory response to the Global Banking Crisis, focused on several issues critical to banking regulation, including:  
  • capital adequacy and liquidity;  
  • accounting;  
  • institutional and geographic regulatory coverage  
    • developing the theme of regulating by economic substance;
  • deposit insurance – greater and more effective protection of retail depositors;  
  • macro-prudential issues;  
  • supervisory approach – suggesting a greater focus on outcomes rather than processes and on regulated firms’ strategies and risk management;  
  • utility versus investment banking – concluding that Glass- Steagall style separation would be impracticable; and  
  • cross-border banking (global and European).  

The Huertas take

In his speech, Thomas Huertas identified important steps in the long-term regulatory agenda:  

  • improving macro-prudential supervision: everyone agrees there have been global failings. Mr Huertas referred specifically to reactions to asset price bubbles;  
  • bringing any “significant financial institution” within the scope of financial regulation: of course, everybody means “hedge funds” and other institutions that act like banks;  
  • strengthening regulation generally: Huertas’ comments focused on capital, liquidity and risk management.

Banks of the future?

There are many possibilities of what a bank will look like in future:

  • will banks choose or be required to separate their deposit and investment operations?  
  • will banks choose or be required to separate retail and wholesale business?  
  • will banks set up separate legal entities everywhere that they operate after the recognised failures of the European passport?  
  • what business models will banks use, now that so many recent models are dead or discredited?  

Huertas said that banks must “conduct themselves correctly” and keep themselves “in sound condition”. He specifically included with this:  

  • proper market conduct;  
  • treating customers fairly;  
  • effective client asset segregation;  
  • conflicts management;  
  • maintaining adequate capital and liquidity; and  
  • risk management – an area where banks need to change their attitudes: models which suggest high rates of return may be ignoring some significant risks.  

Perhaps surprisingly, Huertas did not focus on the aims of outcome-based regulation, the need for regulated firms to comply with the principles of regulation and FSA’s expectations of senior managers. Instead, he spoke of FSA’s new criminal teeth for bringing insider dealing prosecutions, acknowledged that supervisors should not take a “tick-box” approach to supervision (which has allowed banks to get things wrong and then required remedial action or worse), and emphasised another aspect of FSA’s new supervisory philosophy. FSA must be judgmental and forward looking.  

In Huertas’ ideal world, banks would:  

  • offer depositors a safe investment with decent returns;  
  • charge borrowers’ rates which reflect the risk of their default;
  • hold loans to maturity or distribute securities to investors;  
  • trade their trading book assets;  
  • make markets in securities they originate, but carefully and at a low level;  
  • keep higher capital than in the past and run lower liquidity risks; and  
  • not need Government support.  

Supervisors must move early and decisively to deal with banks they are worried may fail. They must be active and co-operative so that they can do their part to ensure banks do not compromise financial stability.  

What Huertas did not say

Huertas said little about the architecture of banking regulation, which other reviews and commentators have addressed in some detail. Specifically, he looked at the separation of regulatory responsibilities and/or financial businesses:  

  • Twin Peaks regulation: whether responsibilities for separate prudential and conduct of business supervision should be assigned to separate regulators;  
  • separate regulators should deal with different types of financial institution, for example, if the prudential (or indeed all) supervision of banks is better done by the central bank; and  
  • the 1930s Glass Stegall model of separation of commercial and investment banking: while the world, the markets and expectations of customers have moved on, many larger commercial banks have perhaps been too confident about their “too big to fail” status. Lord Turner noted G30’s plan to constrain risk taking within large commercial banks, which may in practice lead towards the “narrow banking” model many favour.

The current crisis has done nothing to recommend any one model over another. Countries which have weathered the crisis better than others have done so for various reasons not apparently related to their chosen supervisory structure.

What went after

The London G20 Summit took place the day after this speech. Its conclusions added little to the detailed reports of the preceding months, however, and merely reinforced the moves to: change capital, accounting and liquidity rules; extend the scope of regulation especially in relation to hedge and certain other funds, credit rating agencies, over-the-counter derivatives and remuneration, and macroprudential supervision. It also enhanced the international financial regulatory framework.

What happens next?

There are now so many separate initiatives – global, European and domestic. Some deal with discrete aspects of the need for reform, others deal more generally. The route ahead is unclear, as is the timetable for future actions. Some specific proposals are already drafted, especially in Basel and at EU level, but others are awaited. In the UK, the Turner Review and associated discussion paper close for comment in mid-June, and a UK Government White Paper on financial regulatory reform is imminent. Here, however, the opposition is getting in on the act. Sir James Sassoon’s report to the Shadow Chancellor launched scathing criticisms of the current macro-prudential regulatory model in the UK and proposed sweeping change, including different regulators for macro- and micro-prudential issues and possible replacement of FSA. There has been no indication of how far the Opposition will take these suggestions. What is certain is that change is on the way and bank regulation will be stricter than ever before. What is less certain is when the changes will come and who will police banks in future.