The UK FSA Moves Towards "Twin Peaks" Regulation
Richard Powell | Bloomberg Law
Hector Sants, Chief Executive of the Financial Services Authority (FSA), has announced another significant step towards the fulfilment of the UK Government’s plans to establish a “twin peaks” system of financial regulation. In a speech to the British Bankers’ Association, Sants, who will lead the new Prudential Regulation Authority (PRA), confirmed that authorised firms will, in large part, be supervised according to this model from 1 April 2012.
This news follows shortly after the close of pre-legislative scrutiny of the draft Financial Services Bill, the vehicle for implementing these and other reforms of financial regulation, and the introduction of the Bill into Parliament to begin its legislative passage. Notably, Sants believes that the “biggest challenge” for firms and supervisors is behavioural and not organisational.
Prudential & Conduct Business Units
Currently, the FSA is responsible for both the prudential and conduct regulation of all authorised firms. This model was discredited, though, in the financial crisis, where, among other matters, the new Government elected in 2010 considered that it placed all regulation “in the hands of a single, monolithic financial regulator” responsible for the largest investment banks to the smallest financial adviser.1 In contrast, twin peaks places responsibility for prudential and conduct regulation with two separate regulators, respectively, the PRA and the Financial Conduct Authority (FCA). For practical purposes, the latter will consist of the rump of the FSA after abolition.
Under twin peaks, banks, savings institutions, and significant investment firms, known as “dual-regulated” firms, will be supervised by the PRA on prudential matters and by the FCA on conduct issues. The remainder, and vast majority, of the 20,000-plus authorised firms will be supervised in respect of both prudential and conduct requirements by the FCA.
In anticipation of, and to prepare for, this change, the FSA reorganised its organisational structure in April last year around separate prudential and conduct business units.2 In the autumn, Martin Wheatley, chief executive designate of the future FCA, joined the FSA as head of the conduct business unit. These units will start to operate separately from April 2012.
Sants explains that while the objective is to “replicate” the twin peaks model as closely as possible over the remaining life of the FSA, this cannot be completely achieved. This is because the FSA must operate within the constraints of its existing legislation, the Financial Services and Market Act 2000, its present IT systems, and staff headcount limitations. The FSA has been recruiting heavily since the financial crisis to increase the number and quality of its staff and, therefore, its ability to more pro-actively supervise firms. 2011 saw an increase in its budget,3 funded by industry levies, of 10.1 percent, and an increase of 15.1 percent to £578.45 million for 2012 was recently announced to much industry criticism.4 While citing the fact that 78 percent of FSA supervisors have been employed since July 2007, Sants calls on firms to recognise that the new model will cost more.
The FSA’s business units will not have available the new powers contained in the Bill (e.g., product intervention powers for the FCA), and there will be instances where decisions must be taken on an FSA-wide basis under its board and committee structure.
The move to twin peaks regulation is not simply about regulatory architecture but also sees the consolidation and development of the FSA’s new more intrusive and judgemental style of supervision. In this context, Sants describes the new model’s operating characteristics as follows:
- Prudential and conduct supervisors “will make their own, separate, set of regulatory judgments against different objectives”;
- Supervisors will interact separately with firms but in a co-ordinated manner; and
- Data need only be provided once to supervisors within a common infrastructure.
Sants affirms the importance of supervisors having clear objectives. In this respect, he considers that there was insufficient clarity over the FSA’s regulatory objectives as set out in FSMA.5 The FSA’s prudential and conduct units will have objectives similar to those set out in the Bill for the PRA and FCA. In the case of the PRA, this is “to ensure the safety and soundness of firms and to avoid disorderly failure which has systemic consequences,” and for the FCA this is “to ensure that markets work well by protecting consumers and protecting and enhancing the integrity of markets.”
The high level aside, Sants explained what twin peaks will mean in practice to firms and supervisors. The changes will obviously impact dual-regulated firms the most, as they will be interacting with two different regulators, each with their own regulatory priorities. Accordingly, supervisory practice will gradually begin to diverge. Moreover, supervisory resource will be used differently. The prudential business unit will continue with dedicated expert supervisors for firms with a systemic impact, while conduct supervisors will tend to switch from firm-dedicated teams to focusing on thematic work (i.e., on distinct regulatory issues or concerns).
The first change to be seen by many firms will be the ARROW6 risk mitigation programme, where prudential and conduct business units will each take ownership of their respective parts. Dual-regulated firms will need to respond to both, taking into account that each supervisor will have its own regulatory priorities. Although ARROW is to be retained for the immediate future, it is likely to be replaced in 2013 for conduct matters with “a more focused assessment.”
Firms will also witness a degree of simplification of supervisory work as efforts are brought to focus on priority areas. This could include capital assessments to make resource available elsewhere.
An indicator of the intended behavioural changes required of both supervisors and firms is the abandonment by the FSA of “relationship managers” and their replacement by “lead supervisors.” Sants referred to the FSA’s previous conduct approach, under which it sought to ensure, on the one hand, that consumers had the information they needed and, on the other, that firms had the appropriate systems and controls to treat their customers fairly.7 In future, the focus will be on a firm’s judgement, where supervisors may intervene if they disagree, and on the outcomes experienced by customers.
In this sense, Sants considers that the “tick box” notion of regulation will be gone,8 although he believes that, from a prudential regulation perspective, the greatest risk of such an approach comes from EU legislation. This he describes as a side effect of the European objective of harmonisation. Rather more fundamentally, Sants believes that, prior to 2008, prudential supervision failed to respond to the risks posed to firms having a systemic impact.
Sants is also anxious to achieve agreement and/or an understanding on the question of risk tolerance, on the basis that the regulatory architecture is not seeking to create “a no failure” regime. This echoes the FSA’s Memorandum to the Joint Committee on the Draft Financial Services Bill last September, in which the regulator questioned whether such an approach is realistic or desirable.
The Bill is expected to receive royal assent in early 2013, at which time the PRA and FCA will come into existence with their new powers and responsibilities. In the meantime, the Bank of England, under whose umbrella the PRA will come, and the FSA are expected to publish consultation papers providing more information on how the new regulators will work. There are a variety of questions to be answered such as the application of the threshold conditions for authorisation9 and how to split up the FSA Handbook between the PRA and FCA. A salutary reminder of the context of these reforms, given the increasing role of the European supervisory authorities, is that the PRA’s and FCA’s main tasks will consist of supervision and enforcement rather than policy formation.
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