At last, regulators and policy makers seem to have finished analysing what went wrong with financial regulation. They have started changing laws and regulatory practices to address some of the problems they identified. Now, the Government is looking at whether it needs to make fundamental changes to the structure of regulation and the powers of the regulatory authorities. July brought a flurry of papers.

In this article, Emma Radmore of Denton Wilde Sapte looks at Treasury’s proposals and the consultation paper published by the Walker review team. She also considers the alternative plans of the Conservative Party and the recommendations of the Treasury Select Committee.

Treasury White Paper

First, Treasury published the long-awaited White Paper on reforming financial markets on 8 July. Its aim is to make changes that will:  

  • give more effective prudential regulation and supervision of firms;  
  • place greater emphasis on monitoring and managing system-wide risks;  
  • improve confidence that regulators are equipped to deal with crises; and  
  • give the taxpayer more protection when the Government has to take action in respect of a financial institution.  

It plans to do this in a number of ways:  

  • more powers for FSA: the White Paper does not consider getting rid of FSA. It supports the findings of the Turner Review. It wants to give FSA more powers, including making financial stability a statutory objective and enhancing its powers to deal with individual institutions and market misconduct and letting it get more information from unregulated institutions. This can help determine threats to stability and whether other institutions should fall under FSA’s regulatory remit;
  • a new Council for Financial Stability within the tripartite framework: the Government will keep the basic tripartite structure. It will retain the framework of the Bank of England (BoE) contributing to financial stability with FSA supervising all institutions. But it will strengthen the framework, already started through the Banking Act 2009. BoE will have to identify specific risks and actions in its Financial Stability Report and the Government recognises co-ordination between authorities must improve. The Government plans legislation that will create a Council for Financial Stability of which the Tripartite Authorities will be members. It will have statutory duties to consider and report on matters of financial stability. The Government intends the new Council to consider remuneration at its first meeting;
  • minimising possibilities of institutional failure: building on the approach of the Banking Act to failures, the Government wants:  
    • stronger market discipline (including through the Walker reforms to Corporate Governance and FSA’s Code of Practice);  
    • more stringent regulation of systemically important firms (including their required capital and liquidity levels);
    • firms to have plans for managing their own failure and a better market infrastructure (particularly for securitisations and specific derivatives);  
    • derivatives to be standardised so far as possible, and to clear through Central Counterparties (CCPs).

The Government believes this approach is better than limiting firms’ activities in a Glass-Steagall style approach, or placing arbitrary limits on the size of banks;  

  • changes to FSCS funding: the White Paper suggests pre-funding the Financial Services Compensation Scheme (FSCS) deposit-taking class, so industry can contribute to the costs of a failure before it happens. It also thinks FSCS should be the single point of contact in the UK for other Member States’ guarantee schemes and should act as agent for UK customers; and  
  • better consumer help: the Paper proposes introducing consumer help, such as improving advice on capability and access to simple products. It also wants to improve how to deal with widespread complaints.

In his speech announcing the consultation, the Chancellor stressed the need to maintain competitive markets in the UK to allow new entrants including non-banks. He said he would require FSA to report on compliance with its remuneration code and would expect boards and investors to be involved in risk management, with a greater role for non-executive directors (NEDs).

Corporate governance: the Walker report

Consultation on the Walker report on corporate governance started on 16 July. The consultation document proposes fundamental changes to the way banks’ boards are run, giving much more power to non-executive directors (NEDs), in particular as part of the risk and remuneration process. The major changes Walker suggests are:

Board composition:

  • FSA should pay more attention to balance of bank board composition including the training given to NEDs;  
  • a chairman must have knowledge and experience of the industry and of leading a business and be prepared to spend at least two thirds of his time on that post, and give it priority over other jobs;  
  • the chairman should face annual re-election;  
  • there should be a Senior Independent Director (SID) to be the chairman’s “sounding board”, to help NEDs and be available to help shareholders.  

Risk committees:

  • an NED should chair board-level risk committees, which should be separate from the audit committee and able to block big transactions;  
  • a Chief Financial Officer (CFO) should participate in the risk management and oversight process across the institution at the highest level and should have complete independence;  
  • the board risk committee should have access to, and use, external advice;  
  • the board risk committee should make a separate report within the annual report.  

Remuneration:  

  • remuneration committees should look at pay across the institution and oversee pay of high-paid executives not on the board: what is a high-paid executive depends on the median pay of the institution’s executive;  
  • bonus schemes for all high-paid executives should have a significant deferred element. Even short-term bonus schemes should last three years with no more than one-third of the bonus payable in the first year;  
  • there should be increased public disclosure about pay of high-paid executives;  
  • the chairman of the remuneration committee should face re-election if the committee report gets less than 75 per cent approval;  
  • the committee’s report should include detail on enhanced pension benefits and discretions the committee has exercised.

NEDs:

  • NEDs should spend up to 50 per cent more time on the job (at least 30-36 days). Institutions should provide appropriate training and support to NEDs;  
  • FSA’s approval process should be stricter on NEDs, including interviewing them to assess their knowledge and ability to participate in risk management of businesses.

Role of institutional shareholders:

  • institutional shareholders should agree a Memorandum of Understanding (MoU) on collective action on key issues;
  • shareholders should exercise their voting rights and keep records of what they have done.

Other key recommendations:

  • boards and FSA should be ready to question large changes in shareholdings;
  • the Financial Reporting Council should sponsor the institutional shareholder code, the “Statement of Principles – the Responsibilities of Institutional Shareholders and Agents” should be called the “Principles of Stewardship”; and
  • FSA should monitor conformity and disclosure by fund managers, who should commit publicly to following the Principles of Stewardship.

Walker thinks most recommendations could be enforced using the Combined Code, with the Financial Reporting Council deciding the best way to enforce. Although he used as his base UK-listed banks, he thinks many of the principles should apply, proportionately, to UK subsidiaries of overseas banks and other financial institutions. Walker will issue his final report in November. (Of course, FSA has now published its final code on remuneration.)

The Opposition view

On 20 July the Conservative Party published its White Paper on financial regulation. The paper sets out the Conservatives’ plans for reforming the UK financial services regulatory framework. If elected to Government at the next General Election the Conservatives plan to:

  • abolish FSA and the existing tripartite system; 
  • make BoE responsible for macro-prudential regulation, judging and controlling risks to the financial system as a whole. They will do this by creating a powerful new Financial Policy Committee within BoE, working alongside the Monetary Policy Committee, which will monitor systemic risks, use new macro-prudential regulatory tools and carry out the special resolution regime for failing banks;
  • make BoE responsible for the micro-prudential regulation of all banks, building societies and other significant institutions, including insurance companies. They will do this by creating a new Financial Regulation Division of BoE to carry out this micro-prudential role, headed by a new Deputy Governor for Financial Regulation;
  • reform the structure of BoE to reflect its new responsibilities and ensure the close coordination of monetary policy, financial stability and the regulation of individual institutions;
  • provide BoE with new regulatory “tools” to ensure financial stability. These will include being able to impose greater capital and liquidity requirements to recognise risks concerning the size and complexity of institutions and using higher capital requirements to regulate high-risk activities and bonus structures;
  • ensure there is a single Treasury minister with specific responsibility for European financial regulation;
  • create a new Consumer Protection Agency (CPA) and transfer consumer credit regulation from the Office of Fair Trading (OFT) to the CPA. They say this will create a unified regulatory regime for financial services firms and consumers;
  • force banks to be more transparent about their retail consumer charges; and
  • ask OFT and the Competition Commission to conduct a focused examination of the effects of consolidation in the retail banking sector.

Treasury Select Committee

Finally, on 31 July, the Treasury Select Committee published its final report following its evidence sessions on banking regulation and supervision. In this report it says responsibility for systemic oversight must be clearer. It does not think the tripartite framework needs substantial change, but there must be clearer formal responsibilities for financial stability. Then it will be possible to look at macro-prudential responsibilities. The Committee criticised the Government for not consulting BoE on the content of its White Paper. It noted FSA’s efforts to address the problems in its supervision of the banking sector. It also focused on systemically important banks, saying there should be none that is “too big to save” and no bank must be incentivised to be “too big to fail”. Finally, it says FSA should not rule out banning proprietary trading by deposit taking by banks because banks must not feel they can take risky bets on such trading in the belief Government guarantees will help them.

So what is the shape of reform?

Where this leaves the future of UK regulation is unclear. Fundamentally, there is agreement on rules that need change, and there is already significant action at global, EU and UK levels to address this. In particular, capital and liquidity rules, remuneration practices, derivatives clearing and ways to deal with failing institutions are all at least well advanced.

But who will police these rules and how? It is perhaps not surprising the Government wants to keep the tripartite structure, and particularly FSA, since it was the same party’s brainchild to pass banking regulation to a newly created single regulator in the late 1990s. Conversely, any opposition party may be keen to show this structure has not worked. But it is not clear how the Conservatives’ plans would help, as they appear to create a new set of dual regulation for institutions that operate in both wholesale and retail sectors.

Perhaps the Select Committee’s view is the most balanced: clearly much failed, but FSA has recognised its own failings and the Banking Act has already addressed some cross-regulator failings. What is important is that the right institutions have the right powers to intervene at the right time, so no important warnings are missed and firms are regulated by regulators who understand not only the firms’ business, but the environment and economy in which they operate. Commentators have already given all the reasons for the global economic crisis, and the failure of UK-regulated institutions cannot reasonably be blamed solely on failures in the tripartite system. Now is the time for regulators to have clear powers and the right understanding to regulate their communities properly and sensibly, but without stifling them. The British Bankers’ Association has been vocal among industry associations in stressing the UK should not make sweeping changes before any other country. At least both major political parties seem agreed the UK should make its voice loud in Europe.

So the jury is out on whether the tripartite system, and FSA, is irretrievably broken. But, given the new Banking Act, and increasing EU activity, maybe detailed regulation will change before we have certainty on the future regulatory structure. And, ultimately, that will depend on which party wins the next General Election.

A version of this article first appeared in Compliance Monitor (www.i-law.com)