In a previous alert published in July,The UK's Blueprint for Financial Regulation, we looked at the UK Government's proposals for an overhaul of the UK financial regulatory infrastructure. These proposals were issued upon the initiation of the new Government, aimed at addressing a systemic failure in the UK domestic regime to recognise and respond in a timely and adequate manner to the global financial crisis.

Since July, a consultation paper has been published by the Government which adds some colour to how the proposed new regulatory landscape will look going forward. This article looks at some of the key proposals in this consultation paper and discusses some of the questions that have arisen from the details revealed.

(1) A Reminder . . . The New Structure

Financial Policy Committee (FPC)

What role? At the head of the new structure will sit the new FPC which will be established as a committee of the Court of Directors of the Bank of England (BoE). The FPC's main function will be to undertake macro-prudential regulation. In practice, this will comprise three broad areas: monitoring the financial system to identify risks to financial stability, taking action as necessary to address the vulnerabilities and imbalances identified (or recommending action to the appropriate authority) and communicating to Parliament and the wider public the FPC's analysis and information on the action it has taken.

Efficiency in practice -- what tools? The Government will legislate to provide the Treasury with the power to set out in secondary legislation the precise macro-prudential tools available to the FPC. However, disappointingly, the consultation paper does not contain a great deal of detail on these tools, besides the overview that they are likely to include micro-prudential levers such as counter-cyclical capital requirements, leverage limits, setting limits on borrowing and collateral requirements. In terms of implementation, the FPC will be able to require the Prudential Regulation Authority (PRA) and, if relevant, the Consumer Protection and Markets Authority (CPMA) to take regulatory action to implement macro-prudential policy.

Who? The FPC will have a total membership of 11, comprising six executives of the BoE and five members from outside the BoE, including a representative from the Treasury. The FPC will be chaired by the Governor of the BoE. The chief executives of the CPMA and the PRA will sit on the FPC to ensure that there is close cooperation between the FPC and the two regulators and to ensure that the FPC is kept fully informed of any developments in the spheres of influence of the PRA and the CPMA that may have an impact on financial stability.

Output? The consultation paper envisages that the FPC will publish a regular six-monthly Financial Stability Report which will be laid before Parliament and will include the FPC's assessment of the outlook for the financial sector and a description of the systemic risks and vulnerabilities it has identified, including an assessment of their severity. It has been proposed that the FPC will meet at least four times a year and that a record of each meeting be published within six weeks. The hope is, of course, that these learned reports and the minutes of these lofty exchanges of the FPC will, or will be capable of, translating into real effective measures in due course instead of stagnating as academic rhetoric.

Prudential Regulation Authority (PRA)

What role? The PRA will be one of two new engine rooms of the new structure replacing the Financial Services Authority (FSA). The PRA will be responsible for the authorisation, regulation and day-to-day supervision of all firms who are subject to significant prudential regulation, such as, banks and other deposit takers; broker dealers (or investment banks); and insurers. The PRA will be responsible for granting and amending permissions to undertake regulated activities falling within its remit and will also be responsible for approving persons to undertake significant influence functions in authorised firms.

Who? The PRA will be a subsidiary of the BoE, with its own legal personality and its own board, chaired by the Governor of the BoE. The board will have a majority of non-executive members, who will be appointed by the Treasury. The new deputy governor of the BoE, Hector Sants (currently the head of the FSA), will be chief executive of the PRA and in order to ensure effective working between the PRA and CPMA, the chief executive of the PRA will sit on the CPMA's board, and vice versa.

Output? The PRA will be required to produce an annual report which will be laid before Parliament. The key functions of the PRA will be:

  • Making the rules which govern the performance of regulated activities by financial firms.
  • Exercising judgments about the safety and soundness of financial firms, and taking appropriate action.
  • The authorisation of firms via the provision of permissions to firms to engage in regulated activities.
  • Supervision, and where necessary, enforcement of compliance with rules.
  • The approval of individuals to perform certain controlled functions within financial firms.
  • The raising of levies to fund the PRA's activities.

Consumer Protection and Markets Authority (CPMA)

What role? The CPMA's primary objective is to ensure confidence in financial services and markets, with particular focus on protecting consumers and ensuring market integrity.

The CPMA will:

  • regulate the conduct of all firms -- including all firms authorised and subject to prudential supervision by the PRA -- in their dealings with ordinary retail consumers;
  • regulate dealings in wholesale financial markets, including the conduct of all financial services firms in wholesale markets, firms providing market services (such as investment exchanges and providers of multilateral trading facilities);
  • through its new market division lead on all market conduct regulation, be the lead authority representing the UK in the new European Securities and Markets Authority (ESMA) and be responsible for regulating exchanges and other trading platform providers[1]; and
  • promulgate the rules governing the conduct of financial firms, in both the retail and wholesale sector. It will also grant and amend permissions to carry on non-prudential regulated activities. In addition, the CPMA will supervise and, where necessary, enforce compliance with conduct of business rules, and the prudential activity of firms within its remit.

Who? The CPMA will be independent of the Government, and will take the corporate form of a company limited by guarantee, financed by the financial services industry. The CPMA will be governed by a board with a majority of non-executives, appointed by the Treasury and the Department of Business, Innovation and Skills (BIS).

(2) The Missing Pieces . . . and the Problem with the Jigsaw Pieces Already on the Table

Marriage of the listing authority & corporate governance stewards

One of the more controversial proposals is whether or not to merge the functions currently performed by the FSA in its capacity as the UK Listing Authority (UKLA)[2] with the corporate functions of the Financial Reporting Council (FRC) under BIS (the independent UK regulator responsible for setting corporate governance standards and reporting requirements). The Government believes that, within the proposed new regulatory architecture, there is a strong case for a new super "Companies Regulator" with power to regulate corporate governance, disclosure and the stewardship of institutional shareholders.

Who will be the new criminal prosecutor for market abuse offences?

It is unclear from the consultation paper whether the CPMA will retain the power to prosecute criminal market abuse or whether this will be the job of a new economic crime agency.

Does one into two go? The power struggle between the PRA and the CPMA

The main area of uncertainty in the Government's proposals is how the responsibility for the day-to-day regulation of the financial system will be divided between the two new regulatory bodies, the PRA and the CPMA. The basic principle is that each regulatory authority will be responsible for taking decisions -- for example, on rule-making, authorisation and enforcement -- in relation to the activities that it regulates. However, putting this principle into practice will require a significant degree of cooperation and coordination between the authorities to avoid duplicating efforts, or cutting across each other's work. The consultation paper sets out how the Government thinks this will be achieved but an analysis of these proposals leads us to believe that there is a high risk of duplicative efforts and increased costs for both the regulators and the regulated.

(3) Fallout and Negative Consequences of the New Infrastructure

Why are we starting again?

The overall approach of having a body, the FPC, which oversees the financial system and monitors the system to identify risks to financial stability is to be commended and is arguably much needed in light of the recent global financial crisis. However, the division of responsibilities for the day-to-day regulation of the financial system between two distinct regulators has some obvious drawbacks. It is arguable that it was the style and rigour of regulation that fell short ahead of the global financial crisis rather than the architecture of the financial system. Perhaps, therefore, a few tweaks could have been made to the existing system rather than overhauling the system in its entirety. Moreover, maintaining the FSA as the sole regulator sitting below the new FPC may have been a better option and this would certainly avoid the need for the time consuming and costly exercise of creating two brand new regulators and dividing the FSA rule book and the legislation of FSMA between them. We are, of course, living in a time of cuts and austerity after all. . . .

Brain drain?

Staff resignations at the FSA doubled in the second quarter of this year. 183 people resigned from the FSA between January 1 and July 2 -- more than those who left in all of 2009. Hector Sants' deputies, Sally Dewar and Jon Pain, and Mark Norris, the chief operating officer, have all announced plans to leave the FSA. The plans to return prudential regulation to the BoE and split the FSA's regulatory role between the PRA and the CPMA, coupled with an increase in job opportunities in the private financial sector, has clearly caused many talented employees at the FSA to reconsider their future. It is perhaps time that the Government put a bit more flesh on the bones of their new proposals and moved towards ensuring that the most talented employees at the FSA are reassured about their future within the new regulatory landscape.

Will the UK be pushed even further to the fringes of Europe?

As part of the changes to the regulatory landscape, the PRA will be charged with representing the UK at the new EU banking and insurance authorities, while a markets division within the CPMA will represent the UK in the new ESMA. However, there are concerns, echoed by Liberal Democrat MEP Sharon Bowles in a recent letter to the Government, that because of the changes to the regulatory system, the UK risks being sidelined in its influence over European financial regulation. The main concern is that the division of UK markets supervision into three parts would leave the UK's responsible authority on ESMA, the CPMA, only actually being responsible for about half of ESMA's remit, leaving the UK's views on substantial and relevant issues essentially unrepresented; for example, the macro prudential effect of any invasive market ruling -- in future the responsibility of the FPC -- will not be represented. With London accounting for 60 per cent. of trading flows in securities in Europe, it is crucial that the UK is represented by a strong, unified voice on ESMA, particularly at a time of wide ranging regulatory reform in Europe, such as the proposed changes to the over-the-counter derivatives markets, which may have a huge effect on the financial services industry in London. The UK Treasury has responded by saying that the UK will be appropriately represented on the new European supervisory bodies, only time will tell whether this will be achievable through the new regulatory structure.

(4) Timetable

So, all in all, the consultation paper seems to pose more questions than it answers. It will be interesting to see how the current proposals are reshaped in light of the responses to the consultation paper and, in particular, to see how the roles of the two regulators develop and become more clearly defined. The consultation period has now closed and we understand that ministers hope to start consulting on draft legislation early next year, so we may know more during the second quarter of next year. The FSA, meanwhile, plans a reorganisation that would allow both the PRA and the CPMA to begin operating as shadow institutions in the first quarter of next year. The whole process is expected to be completed by 2012. We await with baited breath to see how the new financial regulatory landscape will unfold.

(5) In Other Regulatory News. . .

. . .not content with redefining the system of financial regulation in the UK, the UK Government is also planning to take its sword to the system of competition regulation: the UK Government is planning to merge the Office of Fair Trading and the Competition Commission into a new "competition and markets authority". A consultation is to be launched, although not until 2011, and since the new authority will require primary legislation, we can probably not expect a new system until 2012 or 2013. Watch this space for further updates.