On Wednesday 8 July, the Government published its long-awaited whitepaper on reforming the financial markets. Notably, the Government stands by the Tripartite framework it implemented and will seek to strengthen it further. The Bank of England and FSA have both been provided with a statutory footing to maintain financial stability, and the Government does not agree that a Glass-Steagall-like separation of banking activities to be the best manner to deal with ‘high-impact’ firms.

Other proposal highlights include raising consumers’ financial capability through a Money Guidance programme funded by the financial services industry. The FSA will require firms to publish their own complaints data, and a form of collective action may be established to enable consumers to enforce their rights to redress. Finally, the Government will support mutuality as an alternative to financial services companies.

This Client Alert sets out a summary of the Government’s proposals detailed in that whitepaper.

Causes of Failure

The whitepaper pins the blame for the financial crisis squarely with the banking sector. It accuses the industry of failing to understand the risks involved in the complex instruments being created and the risks associated with the rapid growth of interconnected, globalised markets for financial services. More specifically, the Treasury states that firms overextended themselves through excessive leverage and risk-taking, an over-reliance on wholesale funding and risky product streams, and poor management decisions in respect of acquisitions.

Strengthening Regulatory Institutions

Maintaining financial stability

The Government believes the current Tripartite framework to be up to the job and will seek to strengthen it further. The Banking Act 2009 requires the Bank of England to develop a strategy for financial stability through its Financial Stability Committee of Court and on the advice of its new Financial Stability Committee, which was established 1 June.

The Bank will continue to analyse and warn of emerging risks to financial stability in the UK through a bi-annual Financial Stability Report, but should in the future identify specific actions that could be taken to counter systemic risks, provide an assessment of their likely effectiveness, and consider how such actions should be implemented.

Council for Financial Stability

The Bank will work with the FSA, which has also been provided with a statutory footing to maintain financial stability. The Bank, FSA and Treasury will interact with each other through a new and formally structured Council for Financial Stability, which will replace the current Standing Committee of the Tripartite Authorities. The Council will have regular meetings and the Chancellor will act as Chair.

The Council will discuss the authorities’ assessment of systemic risk, consider what actions are needed, and provide a means of coordinating the activities of the authorities whenever it will be necessary to do so.

FSA enforcement powers

The FSA’s enforcement powers will be enhanced and it will be required to monitor and mitigate systemic risks. It will be required to pay due regard to the ‘principles of good regulation,’ which include the principles that the burdens or restrictions imposed by regulation should be proportionate to the expected benefits and the desirability of facilitating innovation and competition.

Dealing with failure

The Banking Act 2009 provides the power for the Government to nationalise bank holding companies where the failure of a deposit-taker within a group would cause a wider threat to financial stability. The UK is also consulting on resolution arrangements for investment banks.

Protecting the taxpayer

The Financial Services Compensation Scheme should be financed by the financial services industry as it is the industry that benefits from increased confidence resulting from deposit protection measures. The financial services industry will therefore meet most of the costs of the recent resolutions through the FSCS. However, rather than have the Government lend money to the FSCS for any sudden, substantial failures and have the Scheme pay interest on such borrowings, as has happened recently, the introduction of pre-funding—a system in which contingency funds are built up in advance of a major failure—would spread costs over a period of time and be more appropriate in the future. The Government has taken the decision not to introduce pre-funding before 2012.

Managing Systematically Significant Firms

The problems posed by ‘high impact’ firms can be managed through stronger market discipline, better regulation, and managing failure effectively, and through better market infrastructure. This is believed to be more effective than imposing formal limits on the activities of financial firms through legislation (i.e., the Glass-Steagall approach). In the same manner, there is nothing to suggest that separating deposit-taking business from trading would result in a reduction in the likelihood of failure in the future.  

The Government is providing guidance on standards of discipline in both corporate governance and remuneration. Systematically, significant firms will be required to hold capital and maintain liquidity that reflects the impact their failure would have on the system.  

Managing Systemic Risk

Increasing market transparency and robustness  

The management of risk may be improved through increasing transparency by improving accounting standards and through improving the liquidity, transparency and robustness of wholesale markets. It is proposed that the latter can be achieved by increasing the numbers of buyers and sellers in the market through standardising products and requiring market participants to comply with disclosure and ongoing reporting obligations.

Further, the UK Government supports changes to the EU’s Capital Requirements Directive that will restrict the purchase by EU-regulated banks of securitisations where the originator or distributor does not itself retain a net economic interest of at least 5 percent. This will ensure that the ability to transfer credit risk through securitisation markets does not reduce incentives for those originating and securitising loans to assess and monitor ongoing credit quality.

Derivatives market

Derivatives markets should also become more transparent and robust through the introduction of an EU Clearing and Settlement Directive, thereby harmonising an EU legislative framework for central counterparties. Standardised derivatives should be cleared on a central counterparty, and the counterparty risk for bespoke products should be mitigated through bilateral collateralisation and risk-appropriate capital charges.  

International Cooperation

Certain measures are only effective if implemented on an international basis. These include rules requiring additional capital to be set aside during periods of growth, discretionary variations of regulatory requirements by national authorities, and particular restrictions on loan products, such as maximum loan to value ratios for mortgages.  

Supporting and Protecting Consumers

Increasing financial capability

The Government is seeking to protect consumers from their engagement with providers of financial services by raising consumer financial capability. This will be achieved through introducing personal finance programmes in schools, giving adults access to generic financial advice (the so-called Money Guidance service), and by promoting financial capability through Government programmes.

A large-scale pilot scheme of the Money Guidance service has already begun in the North of England and provides advice on issues such as budgeting on a reduced income, understanding the benefits available after the death of a spouse, and how to find a good deal on an annuity. Financial services firms will contribute to the funding of the Money Guidance service.

Access to simple, transparent products

The Government would like to introduce a system that allows consumers the option of investing in easy-to-understand, cheap products, whilst those who choose to invest in more sophisticated products do so knowing of the cheaper and simpler alternatives. One option proposed to improve the transparency of financial products is the ‘traffic-light’ system that has been introduced into food labelling.  

Consumer protection

The management of widespread complaints will be improved by making better use of complaints data, doing more to invite referrals, encouraging whistle blowing, and encouraging consumers to come forward at an earlier stage. From this autumn, the Financial Ombudsman Service will publish firm-specific data on the volume of complaints it has dealt with, and the FSA will shortly be consulting on a proposal to require firms to publish their own complaints data. The Government is also inviting views on proposed legislation to introduce a form of collective action that consumers can enforce their rights to redress.  

Enhancing Competition

Market access

The Government will seek to strengthen competition through a number of measures, including supporting new market entrants through proposals to make the switching between personal current accounts easier for consumers. The OFT is already engaged in discussions, and the FSA will have a greater role to play from November 2009 when it assumes control of the retail banking business conduct from the Banking Codes Standards Board. Supporting mobile phone technology, such as the M-PESA system in Kenya—which allows users to transfer cash via text message and which is available to customers without a traditional bank account—will also offer opportunities for new entrants.

The Government proposes that the OFT and FSA focus on market access. The FSA should specifically address this issue when conducting a cost benefit analysis on new regulatory proposals. The OFT should address market access as part of its annual updates of its Financial Services Strategy.  

Supporting mutuality

Diversity will be maintained through supporting mutuality as an alternative to financial services companies. Measures currently making their way through Parliament include those to improve the corporate governance of Industrial and Providence Societies (IPSs) and credit unions, such as ensuring that officers of IPSs are subject to similar sanctions as directors of companies, and providing for the FSA to be given new powers to investigate IPSs. The Government is also bringing forward proposals to reduce administrative burdens on credit unions and IPSs.  

Legislation was introduced in 2008 to enable building societies to grant floating charges to the Bank of England in relation to the provision of liquidity support. The Government is now proposing measures to make it easier for building societies to raise money from Treasury bills or other securities issued by a central bank. The Government may also implement legislation in the future that will allow building societies to increase the proportion of capital they are allowed to raise in the wholesale markets to 75 percent.  

Social Investment

The Government is launching a consultation on the design and functions of a Social Investment Wholesale Bank to support not-for-profit investors and lenders through additional private capital. Such a bank would increase the supply of investment capital in the so-called third sector to help develop and support the social investment market