HM Treasury has very recently published a memorandum submitted by the FSA in response to its inquiry into the Government's proposals for reform of financial regulation. The memorandum sheds some light, for the first time, on how the FSA is implementing the new regulatory structure and its assessment of the associated key risks. The memorandum also sets out some of the FSA's concerns about the new regulatory framework, many of which are consistent with those being raised within the industry, and the key opportunities that the new regulatory architecture presents. This briefing summarises the matters raised in the memorandum.

Click here for a diagram of the new UK regulatory structure and the interplay with the new European Supervisory Authorities. Click here for a table of the key features of the Prudential Regulation Authority (PRA), Consumer Protection Authority (CPMA) and the Financial Policy Committee (FPC), including their respective scope of regulation, key responsibilities and functions.

How is the FSA going about the "de-merger"?

The FSA has established a programme, led by the FSA Executive Committee, working with the Bank of England and HM Treasury, to design the regulatory and operating model for the new regulatory authorities and to manage the transition to the new structure. The FSA intends to move to an internal "shadow structure" in early 2011, whereby it will allocate FSA staff and responsibilities in anticipation of the formal creation of the PRA and CPMA. This interim measure is being put in place so as to assist in the smooth migration to the new structure, and to allow time to modify the operational aspects of the new approach before the "cutover" six months ahead of the Government's stated intention that the new bodies will be operational on 1 January 2013.

The FSA will seek to "lift and shift" divisions which clearly relate exclusively to either PRA or CPMA functions without significant change. However, the FSA acknowledges that this will not be possible in many cases given that many supervisory teams deal with both prudential and conduct of business activities. The memorandum does not go as far as stating exactly where any unit or division within the FSA will be allocated within the shadow structure.

Requirement for new supervisory processes

The memorandum confirms that the new regulatory framework will require a "complete redesign" of the FSA's underlying supervisory processes. For example:

  • The ARROW supervisory risk framework will be divided to the new agencies.
  • The authorisation process will be divided to allow the PRA and CPMA to take responsibility for its own authorisation decisions. This implies that there will be two separate authorisation processes.

The FSA does not provide any further information on how exactly the supervisory process will change.

Risks in transition to new structure

The FSA acknowledges that "executing the de-merger of the FSA is a complex and resource-intensive exercise with significant execution risk". It sees the key risk areas to be:

Adverse impact on FSA's ability to discharge its statutory obligations

The FSA notes that the increase in management time required in the design and transition to the new structure is likely to impact adversely on its ability to discharge its statutory functions. The risks identified by the FSA are:

  • The FSA will not deliver the same level of supervision as it currently does - the FSA states that "inevitably the amount of time spent on pre-emptive routine supervision will decline over the transition period". This statement sits somewhat uncomfortably with the FSA's recent determination to increase its supervisory efforts so as to deliver an "intensive supervisory" approach. However, there is clearly an intention of return to (and indeed build on) their "intensive and intrusive" supervisory model where possible.
  • The FSA's ability to influence developments at the European level will reduce. This statement is a particular concern given the growing importance, scale and impact of regulatory changes currently taking place in the European arena.

Break in continuity of regulatory interface with firms

The FSA states that the transition to the new structure will "involve a change in the manner of our dealing with firms and potentially also in the composition of the supervision teams". Further that this will risk a reduction in the effectiveness of engagement with firms, given the break in continuity in dialogue between firms and the FSA. This supervisory disruption is of course wholly unwelcome, particularly at this time of uncertainty.

Staff retention issues

The FSA acknowledges that the uncertainty of migrating to the new structure poses retention and recruitment problems. It notes that there are retention pressures in certain key skill areas, for example some areas within the Risk Business Unit. One of the FSA's responses to the increase in staff turnover will be to increase the use of external contractors, and to consider retention payments and/or salary increases.

Risks associated with new regime

Whilst the memorandum does not comment on the Government's proposals as a whole, it highlights certain key concerns as follows:

Loss of an integrated regulatory approach

The FSA has reiterated longstanding concerns that in moving to a supervisory framework split between the PRA and CPMA, there will be a loss of an integrated supervisory approach. The FSA highlights the risk of firms exploiting the differences in the approaches of the new regulators. Further, it notes that there may be difficulty in recruiting prudential expertise in the CPMA, as required for the prudential regulation of firms not falling within the PRA's remit.

Weakened voice in European and International regulatory fora

The FSA has rightly highlighted that once the new framework is in place, there is a risk that the power of the UK to influence European and International regulation will diminish, in that two regulatory bodies will share the representational role in the various overseas regulatory committees. This is particularly so in relation to the three new European Supervisory Authorities, where the UK will only have one vote on each committee.

Issues arising in markets oversight

The FSA has echoed concerns which currently abound, regarding the proposal to create a tripartite system for markets regulation, consisting of: the Financial Reporting Council (primary markets regulation), the CPMA (secondary markets regulation), and the Bank of England (post trade regulation). In particular, the FSA believes this system will result in the fragmented representation in European and International fora and problems in the separation of primary and secondary markets regulation.

Hiving off of criminal enforcement powers

The FSA makes its view clear that criminal prosecution functions for market abuse should remain with the CPMA and not be transferred to a new Economic Crime Agency. It is interesting to note that the FSA states that the lack of clarity on this issue has affected the FSA's planning process and staff retention and recruitment.

Opportunities

The FSA also considers there to be opportunities arising from the new regulatory regime. It believes the principal benefit to be the creation of a comprehensive framework for addressing macro-prudential issues, which will address a gap in the present regulatory system. The FSA also welcomes the opportunity to build on improvements to the supervision of conduct and prudential matters and to improve the regulatory framework particularly with regard to consumer protection.

Next steps

2010

  • 18 October - deadline for responses to HM Treasury's consultation on reforms to UK financial services regulatory architecture
  • Autumn - interim FPC to be established within Bank of England
  • Autumn - HM Treasury and BIS to publish a joint consultation on consumer credit regulation
  • 15 November - deadline for responses to Independent Commission on Banking (ICB) issues paper (click here for our briefing)
  • 23 November - FSA to give oral evidence to HM Treasury's inquiry into financial regulation reforms

2011

  • Early 2011 - FSA to move to shadow internal structure
  • Early 2011 - detailed proposals on core parts of draft legislation reforming UK financial services regulatory architecture to be published for consultation
  • Spring - ICB to publish detailed analysis of leading reform options
  • End of September - ICB to make final recommendations

2012

  • Primary legislation implementing new regulatory structure to be enacted, with secondary legislation and administrative measures to be enacted thereafter

2013

  • 1 January - full implementation of new UK financial services regulatory architecture 

Click here for our briefing which draws out some areas of the proposed reforms which we believe require further thought and clarification from the Government.