Japan's financial regulator, the Financial Services Agency (Japanese FSA), has not been subject to clear pressure to reform unlike regulators in most other developed capital markets. Indeed the Japanese FSA could be said to have had a "good crisis" over the last few years. However, developments in other financial markets are likely, as before, to influence the direction of regulation in Japan, not least because increased interaction and cooperation with G20 partners is a goal of Japan's regulators. The UK's Financial Services Authority (UK FSA) has operated as a model for the Japanese FSA in the past: for example, the principles issued by the two bodies are similar, as was the concept of "better regulation" (deregulation). However, the Japanese FSA never went as far as the UK FSA in relaxing its controls. Nevertheless, the proposed dissolution of the UK FSA and related regulatory reforms, which are the subject of this newsletter, should be of interest to market participants in Japan. Japan's FSA is also tasked with a role that stretches from systemic, prudential oversight to detailed conduct-based inspections and consumer protection. As is being suggested in Germany also, a larger role for the central bank or other similar body with separate prudential regulatory responsibilities, may be desirable. It is evident that Japan's FSA and Securities and Exchange Surveillance Commission (SESC) have been highly and successfully focused on conduct issues in recent years. The changes in the UK will be introduced over the period 2011 to 2013. Japan's FSA may also be required to think about similar changes in coming months and years.
In June this year, the UK Chancellor announced the government's plan for a wholesale reform of the financial services regulatory architecture in the UK. This was followed by a consultation from HM Treasury in July seeking views on the Government's proposals, which include abolishing the current regulator, the Financial Services Authority (UK FSA), and handing over its existing supervisory functions to the Bank of England (Bank) and various new bodies. This newsletter summarises the key points arising from the UK Government's proposals.
Reasons for reform of the UK financial regulatory regime
Responsibility for financial stability in the UK is currently shared between HM Treasury, the Bank and the UK FSA, together referred to as the "tripartite authorities". During the recent financial crisis, the flaws of the current tripartite system of regulation became apparent. The tripartite authorities failed to identify the problems which were building up in the financial system and did not take steps either to mitigate or adequately deal with the ensuing crisis.
An important failing of the tripartite system is that no single institution within the tripartite model has the responsibility, authority or powers to monitor the system as a whole, identify potentially destabilising trends and respond to them with concerted action. It places responsibility for financial regulation in the hands of a single regulator, the UK FSA, which was expected to deal with issues ranging from the safety and soundness of global investment banks through to the customer practices of high-street financial advisers. The UK FSA did not have a sufficient macro-prudential focus and did not ensure that risks which were developing across the financial system as a whole were identified and responded to. The Bank has not, until recently, been given tools to carry out its responsibilities for financial stability and HM Treasury's responsibility for maintaining the overall legal and institutional framework meant that it did not have clear responsibility for dealing with the financial crisis.
It is clear that change is needed to improve the system. However, the new government has gone beyond tinkering with the existing structure and is consulting on a wholesale reform of the UK financial services regulatory regime.
The proposed reforms
The FPC, PRA and CPMA
Under the proposals, the current tripartite system of regulation will be abolished. The changes will give the Bank control of macro-prudential regulation and oversight of micro-prudential regulation for systemically important financial firms. The UK FSA will cease to exist and the following regulatory bodies will be established:
- A Financial Policy Committee (FPC) will sit within the Bank and will be responsible for macro-prudential regulation and maintaining financial stability. The FPC will work internationally with similarly systemically-focussed authorities, such as the G20 Financial Stability Board, the European Systemic Risk Board and national regulators to co-ordinate macro-prudential policies.
- A Prudential Regulatory Authority (PRA) will be created as a subsidiary of the Bank, to be responsible for prudential regulation of systemically important financial institutions, including banks, investment banks, building societies and insurance companies. The Government believes that the Bank of England, with its macroeconomic expertise and system-wide remit as a central bank, is the most suitable candidate for taking on prudential regulatory responsibilities. However, the PRA will be a separate legal entity from the Bank of England, so that the day-to-day operations of firm-specific regulation will be undertaken by the PRA, and not by the Bank. By focussing solely on prudential regulation, it is thought that the PRA will have more opportunity to develop expertise in this area, unlike the UK FSA, which is currently both the prudential and conduct regulator, and has in the past been overly focussed on conduct issues.
- A Consumer Protection and Markets Agency (CPMA) will regulate the conduct of financial institutions providing services to retail consumers and ensure good conduct of business in wholesale financial markets. It will regulate the conduct of all firms, including all firms authorised and subject to prudential supervision by the PRA. It will also be the prudential supervisor of those firms (including insurance intermediaries, mortgage firms and most fund managers) which are not subject to prudential regulation by the UK FSA.
Regulation of listing and related activities
It is still uncertain which regulatory body will assume the functions of the UK Listing Authority (UKLA), which currently forms part of the UK FSA. The Government is consulting on whether the UKLA should be merged with the Financial Reporting Council (FRC) under the Department for Business, Innovation and Skills (BIS) (thereby bringing it alongside the FRC's functions relating to company reporting, audit and corporate governance), or with the markets division of the CPMA. There will be a separate consultation on this by BIS in due course. It has already been argued by a number of market participants that the regulator responsible for primary market activity should also have responsibility for secondary market activity. If this argument is accepted, the CPMA would be the obvious body to assume responsibility for the regulation of both primary and secondary market activity.
The Government had indicated previously that it would transfer responsibility for the prosecution of criminal offences relating to market abuse and other criminal law breaches which the UK FSA and other regulatory bodies such as the Serious Fraud Office and Office of Fair Trading currently prosecute, to a new Economic Crime Agency (ECA). No further details are revealed in the consultation paper – this will be subject to separate consultation in due course. The UK FSA has made much of its criminal prosecution powers as part of its recent policy of "credible deterrence" and a number of questions have already been raised about how the proposed division of criminal and civil enforcement powers between the CPMA and the ECA could affect the future viability of this policy.
HM Treasury and BIS will publish a joint consultation on how the legislative framework for consumer credit regulation might be simplified and whether it should be brought under a single regulatory regime for which the CPMA would be the obvious regulator.
The legislative framework
The Government will examine the adequacy of the Financial Services and Markets Act 2000 (FSMA) as the suitable legal framework going forward. If FSMA is to be the model for the legal framework, the Government will legislate to divide the powers and functions set out in FSMA into separate standalone prudential and conduct regulation frameworks. It is acknowledged that in some cases there may be overlapping powers and functions.
The new institutional structure is expected to be formalised by 2012 with full implementation of the new architecture by 1 January 2013. A Bill, implementing the reforms, will be brought forward in mid-2011 and the Government will seek to ensure the passage of primary legislation within two years.
In early 2011, the UK FSA will prepare for the transition by establishing a 'shadow' internal structure, which will allocate UK FSA staff and responsibilities in anticipation of the formal creation of the CPMA and the PRA. An interim FPC will be established to carry out preparatory work and undertake, as far as practicable, the permanent body’s macro-prudential role.
Having identified the failings of the current structure, many commentators have argued that the better option would be to make changes to the existing structure rather than dismantle it in its entirety. However, it is unlikely that there will be any major deviation from the current proposals. This reflects the political origins of the proposed reforms, the abolition of the UK FSA (a creation of the last Labour Government) being something which the Conservative Party promised to do in its manifesto for the General Election held in May this year. It is interesting to note that Germany, with its integrated regulator, is also considering institutional reform that would put the Bundesbank back at the centre of supervisory power. As in the UK, this move has strong political roots.
The proposed reforms will present various challenges, not least the agreement of the detail of the responsibilities of the new regulatory bodies. Careful consideration will be required to ensure that there is no "underlap" of responsibilities, particularly between the PRA and the CPMA. There is also likely to be significant overlap of the supervisory activities of the PRA and CPMA in relation to firms regulated by both which will need to be carefully thought through and co-ordinated, for example, the granting of permissions, the approval of individuals working at regulated firms, the approval of controllers of regulated firms and the conduct of supervisory visits and enforcement activities. Clearly the ideal outcome for dual regulated firms is an agreed approach that requires only one set of approval applications to be made (rather than two).
The cost of the reforms is estimated at £50 million spread over three years. This would be a small price to pay if the reforms can prevent another financial crisis. Whether or not the proposed changes will be successful remains an open question.