Proposals for the Future of UK Banking Supervision by the New PRA, Contributed by Rhodri Jones and Julie Patient, Hogan Lovells International LLP
In June 2010, the Government announced its intention to restructure the UK’s financial services regulatory framework.1 Central to this is the replacement of the Financial Services Authority (FSA) with a new “twin peaks” regulatory structure that combines oversight of the financial system as a whole with firm-specific supervision.
The Bank of England (BoE) Financial Policy Committee (FPC) will take responsibility for “macro-prudential” regulation, focusing on the overarching stability of the financial system. Conduct of business regulation for all firms will be the responsibility of a new regulator, the Financial Conduct Authority (FCA). The FCA will also be responsible for the prudential regulation of firms which fall outside the remit of the other new regulator, the Prudential Regulatory Authority (PRA). Firms regulated by the PRA will therefore be “dual-regulated,” with the PRA responsible for their prudential regulation and the FCA responsible for conduct of business supervision.
The PRA will be responsible for “micro-prudential” regulation, with an objective of promoting the safety and soundness of regulated firms. The FSA views the PRA’s focus on promoting the stability of the system by concentrating on the firms themselves as being consistent with their shift, since 2008, to a more intrusive and intensive regulatory style. Crucially, the PRA will seek to achieve its objective without supporting a “zero-failure” regime, instead looking to managing the systemic impact of any such failure.
The PRA’s primary remit is to supervise and authorise deposit-takers and insurance companies; however, its scope will extend to the regulation of investment firms that present a significant risk to the stability of the financial system. The PRA will determine whether a firm satisfies this criteria, with the relevant considerations likely to include the firm’s size, the “substitutability” of its services, and its interconnectedness with other parts of the financial system. Despite the PRA’s apparent discretion, both HM Treasury and the FSA have suggested that only a sub-section of larger (i.e., BIPRU 730k2) investment firms should be regulated by the PRA. Control mechanisms will also be placed upon the PRA’s ability to select investment firms, including a requirement to consult with the FCA and a right of representation and appeal for firms.
Firms within the scope of the PRA’s remit will apply to the PRA for authorisation, which will assess whether that firm satisfies the statutory threshold conditions. The current draft of the Financial Services Bill proposes relatively few changes to these conditions, meaning that factors such as suitability and resources will remain central. Although these threshold conditions form the key criteria on which the PRA should theoretically focus on, the BoE has indicated that it intends for the PRA to carry out a wider assessment, with decisions made on a “whole firm” basis and taking into account factors such as governance, risk management and resolvability.
The PRA will lead the authorisation process for these firms. However, it will require the consent of the FCA to grant a firm permission. The PRA will also be responsible for the approval of individuals who may have a significant influence over a firm’s affairs, assessing their probity, integrity and competence. Again, the PRA will be required to work closely with the FCA, with the possibility of jointly publishing a list to clarify which roles each regulator will take responsibility for approving. Initial suggestions for the PRA’s responsibilities include the roles of chairman, chief executive, risk and finance directors, key non-executive directors and the chairmen of any risk, audit or remuneration committees.
The PRA’s supervisory approach is to be based on forward-looking judgements. Firms will all be subject to baseline supervisory monitoring, including assessments of the principal risks from a firm or its sector, discussions with senior management and confirming compliance with capital, liquidity and large exposures requirements. Supervision will be more extensive for firms that pose a greater risk to the system. This may include ongoing analysis of a firm’s financial position, business model, governance and risk management, as well as regular stress testing against possible future states of the world, and an assessment of resolvability and resolution plans.
To support this, the PRA will develop a new risk assessment framework that will replace the FSA’s ARROW approach and allow a specific supervisory strategy to be developed for each firm. This framework will seek to measure the potential impact of a firm’s failure on the financial system, as well as the viability of a firm’s business model and its overall safety and soundness. Another new framework, the Proactive Intervention Framework (PIF), will support the early intervention of the PRA through the identification of risk, allowing firms to take appropriate remedial action and prompting the PRA to prepare for a failure, including co-ordination with the BoE and Financial Services Compensation Scheme (FSCS) if appropriate.
Given the Government’s emphasis on avoiding the use of public funds to support financial institutions in the future, resolvability will play a central role. The PRA will use resolvability analysis to develop a view of the effectiveness of a given firm’s resolution plan. Firms will be required to identify critical economic functions, such as deposit-taking, and assess the extent to which these can be separated at resolution. If any barriers to doing so are identified, the PRA will work alongside the firm to eliminate them. As a minimum, firms will be expected to have the capacity to provide a single view of depositors’ funds to allow rapid payout from the FSCS and to protect connectivity to payment systems.
In support of this, the PRA will look for firms to be more proactive in understanding the circumstances in which they might fail. To this extent, firms are expected to engage in reverse stress tests and identify scenarios that are most likely to lead to failure. Similarly, recovery plans will need to be in place, designed to support a return to a sustainable position following systemic stress and providing options to address capital, liquidity or profitability pressures. This focus on resolvability has received the support of the International Monetary Fund; however, it is recognised that further improvement is required both nationally and internationally to ensure a resolution framework exists that is capable of dealing with the failure of a complex multinational institution.
The PRA will have a range of powers to support it in achieving its regulatory objective; however, the preference is for powers to be used to ensure a firm takes remedial action rather than rely on enforcement action. The PRA will monitor the appropriate amount of capital and liquidity for a firm and will, in the first instance, suggest that a firm make changes. Failure to act on such a request will lead to the PRA using its statutory powers to compel firms to take a certain course of action, potentially through the removal or restriction of a firm’s permission.
Recourse to the courts to ensure compliance remains a possibility; however, the focus appears to be on supporting the collaborative relationship between the firm and the regulator. This aim is furthered through the PRA seeking to develop clear expectations against which firms will be judged, to be set out in a rulebook. Policies and rules will include explanations of their purpose, and firms will also be expected to comply with the spirit of these rules. It is expected that the PRA rulebook will represent a significant reduction in material from the existing FSA handbooks, and will be accompanied by a reference document clearly setting out the PRA’s approach to regulation and supervision.
The “Raised Eyebrow”
Despite the maintenance of a rulebook, the Governor of the Bank of England, Sir Mervyn King, recently stated that a preferred approach would be to give the PRA the ability to make judgements freely.3 The belief being that the FSA’s legalistic approach to its rulebook assisted firms with engaging in “creative compliance,” risking stability while technically remaining within the rules. His belief is that the PRA should be able to say that a firm’s conduct “hasn’t broken any rules, but it is highly risky and we want you to change it.” To some extent, this appears to represent a return to principles-based regulation, albeit coupled with more intense and specific regulation of each firm.
For this approach to succeed, the PRA will need to ensure it has the necessary expertise to understand firms’ products and businesses, with a lack of industry knowledge being a common criticism of the FSA. Hector Sants, the PRA’s prospective chief executive, has suggested that assigning specific supervisors to firms will allow a better understanding to develop; however, it is recognised that the regulator may struggle to attract and retain staff, posing a challenge to the sustainability of this supervisory model.
A paradox also exists between the development of a more intensive relationship between the regulator and the firm, while also attempting to maintain an independent style of regulation. Both Sir Mervyn and Hector Sants have emphasised that the PRA needs to work closely with firms, but also recognise that the FSA’s past approach sometimes risked regulatory capture.4 To remedy this, Sir Mervyn suggested that FSA-era practitioner panels may no longer form a part of the PRA’s policymaking, and it is recognised that the PRA will need to have greater respect and authority to regulate and intervene. However, despite this, the close level of co-operation this style of regulation requires may make it difficult for the regulator to maintain distance.
Co-ordination Between the PRA & FCA
Co-ordination between the PRA and FCA is essential to allow both institutions to achieve their objectives, and to avoid the risk of regulatory under- or over-lap. HM Treasury intends to introduce a statutory duty to co-ordinate the exercise of their functions, an obligation to draft a memorandum of understanding, and require cross-membership of their respective boards. However, the PRA will have the ability to exercise a veto if a course of action cannot be agreed and the PRA is concerned that the FCA’s proposed action would lead to systemic instability.
The PRA and FCA will also need to ensure that their respective rulebooks remain compatible, with mechanisms in place to ensure consistency is achieved. The PRA will be required to consult before making rules, including with the FCA, and will be required to analyse the costs and benefits of proposed regulation. Disagreements will be referred to the FPC for its recommendation; however, irrespective of the FPC’s decision, the PRA will retain the right to veto the FCA’s suggestion if the appropriate circumstances arise.
The relationship between the PRA and FCA presents a challenge to the new structure, despite the introduction of mechanisms, such as the veto, to address the issue. To help manage this, the FSA is aligning its internal management structure to reflect the split responsibilities, effectively allowing a “soft launch” of the two regulators prior to the new structure’s formal introduction in 2013.
With the PRA’s attention necessarily leading it to pay closer attention to large, multinational institutions, it is expected to play a leading international role. For UK-based multinational banks and the UK subsidiaries of international banks, the PRA will consider risks attaching to the group as a whole and will discuss resolvability with overseas supervisors to ensure risk to the UK’s economic stability is minimised. One unresolved issue is the limited control the PRA can exercise over banks established within the European Economic Area passporting into the UK. To counter this, the PRA will play an active role in Europe, seeking to develop the capacity of home state regulators to ensure effective resolution is possible. However, the FSA and BoE recognise this risk remains for the time being.
The FSA, BoE and HM Treasury believe that by only providing the PRA with a single objective, it will be better able to focus efforts on achieving the stability of individual firms. There is merit to adopting this approach and the need to shift to a more intrusive and intensive style of regulation has become apparent. However, it remains clear that there are significant challenges that need to be met prior to the PRA’s formal launch in 2013 to ensure that the institution has the requisite capability and expertise to allow this new model to succeed.
(c) 2011 Hogan Lovells International LLP
Rhodri Jones is an associate in the London office of Hogan Lovells International LLP. He is a member of the firm’s Financial Institutions Group working in the Commercial and Retail Banking Team. Rhodri has a range of experience advising clients on regulatory, product and transactional matters. Telephone: +44 (0) 20 7296 5735; E-mail: rhodri.jones@hogan lovells.com.
Julie Patient is Of Counsel in the London office of Hogan Lovells International LLP. Julie is a member of the firm’s Financial Institutions Group working in the Commercial and Retail Banking Group. She has extensive experience of the regulatory regime impacting participants in the UK market. Julie has specialised in this area for more than 15 years and has acted for major international financial services providers. Telephone: +44 (0) 20 7296 5790; E-mail: email@example.com.
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