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We need a fresh approach to regulation.  The plain fact is that the FSA did not succeed in protecting consumers from spectacular regulatory failures.” 

This is a comment made by Andrew Tyrie, the Chair of the Treasury Committee, on the Treasury Committee’s report on the Financial Conduct Authority (FCA), which was published on 13 January 2012 (the “Report”).  But to what extent is Mr Tyrie’s remark more than just a press-friendly soundbite?  This article will examine whether the creation of the FCA (and the changes to the draft legislation proposed by the Treasury Committee) will bring with it a truly novel approach to financial regulation.

The Three Musketeers

In June 2010, the government announced that, as part of the restructuring of the UK’s financial regulatory framework, it intended to replace the Financial Services Authority (FSA) with two new successor bodies: the FCA and the Prudential Regulation Authority (PRA). A third regulatory body, the Financial Policy Committee (FPC), will also be created which will monitor the stability of the financial system on a macro level, but will not have direct regulatory oversight of any particular types of firms.

The mandate of the PRA is to regulate, in a prudent manner, banks, insurers and complex investment firms.  The FCA’s strategic objective is far broader: it is tasked with protecting and enhancing confidence in financial services and markets, which includes the protection of consumers and the promotion of competition.  The FCA will, therefore, take over most of the FSA’s existing functions.

The FCA will come into being pursuant to the Financial Services Bill (the “FS Bill”).  The Government has set itself an ambitious time-scale of around 18 months in which to pass the FS Bill: from the publication of the draft version of the bill in June 2011 to intended Royal Assent before the end of 2012, with the FCA to be up and running in early 2013.  This has caused concern for the Treasury Committee because of the size of the reforms and the “lack of clarity in some of the proposals.”

The Poor Relation

In order to avoid the FCA becoming what Andrew Tyrie describes as the “poor relation among the new institutions”, the Report sets out a number of key recommendations.  Amongst those are that:

  • the relationship between the FCA, PRA and FPC should be set out more explicitly in legislation and the right to veto decisions of the FCA should lie with the FPC, rather than the PRA
  • the regulatory approach towards each class of regulated activity should be differentiated
  • a proportionate level of contact is maintained across all industry sectors, and not just with the largest firms or those from a particular sector
  • when regulatory material is released by the FCA, it should be accompanied by adequate clarification to all affected firms

It is estimated that in the region of two thousand firms will be dual-regulated by both the PRA and the FCA, such as banks, insurers, and credit unions.  The downside for firms with this approach is that it places a greater regulatory burden upon them, particularly where those firms’ business models are not divided according to prudential and conduct issues.  If firms, therefore, place a greater importance on prudential issues, because there will be a more prescribed regime to follow, rather than conduct issues, this may result in the very failures that this wholesale regulatory reform is seeking to avoid.  A dual approach may lead to over-lap and over-regulation in some areas and under or no regulation in others.   Therefore, the Treasury Committee wants the relationship between the three regulators to be very mapped out to avoid a regulatory lacuna or over-burdensome and conflicting regulation.

In addition, it is proposed that the PRA has a right to veto any actions by the FCA which the PRA considers  might undermine the stability of the UK financial system or result in a significant failure by a PRA authorised.  The Treasury Committee considers that this power should be deleted, or if there is to be any kind of right to veto, it should be held by the FPC.  The Treasury Committee agrees with the views of many interested parties that the power of veto could lead to the FCA being seen as subservient to the PRA or second class.  Which? Has said that it could result in: “the concept of ‘too big to fail’…being extended to ‘too big to be forced to treat your customers fairly’.”  The danger in the FCA being seen to be a second class regulator is that it affects the FCA’s ability to perform its function effectively. 

24,500 firms will be subject to the FCA’s micro-prudential supervision and the FCA will also act as the conduct authority for 27,000 other firms.  The sectors in which these  firms operate include personal investment firms, mortgage intermediaries, retail and wholesale banks and securities firms.   Firms are already complaining that a ‘one-size fits all’ regulatory approach will not work, with smaller firms disproportionately affected by costly and time-consuming regulatory burdens.   The Treasury Committee has expressly advised in the Report that the Government at least considers whether there is any scope for differentiating between classes of financial services activity.

And in relation to those smaller firms, the Treasury Committee recommends that the FCA maintains a proportionate level contact across all industry sectors and not just the largest ones or those from a particular industry sector.  The rationale behind this is that if firms are in communication with the FCA, then its objectives are more likely to be achieved because issues will be spotted before they become a serious problem.    However, many firms, and not just the smaller ones, found that their dialogue with the FSA has been unclear, and that they have not understood what the FSA has required of them.  The Treasury Committee recommends that whenever regulatory material is released by the FCA, it is made quite plain what is expected of whichever firms will be affected at the time that material is published.

The Treasury Committee’s aim is that, if all these recommendations are taken into account in the final draft of the FS Bill, the FCA will be a vast improvement on the FSA.  The authors consider that this requires greater scrutiny.  For example, as discussed above, the Treasury Committee recommends that both the FCA and the financial services industry should make better efforts to communicate with each other.  Andrew Tyrie stated: “too often we’ve heard that the FSA is aloof and unapproachable and that…firms are nervous about approaching them…encouraging a greater level of engagement between firms and the regulator is in the consumer interest.”  That is a worthy sentiment but fails to reflect the reality that a regulator has to balance the competing interests of both a vibrant financial sector that contributes to the UK economy whilst protecting the interests of consumers. On a practical level, the FCA will comprise the same people performing very similar roles to those they perform now at the FSA.  If those FSA personnel did not, or could not, anticipate historic events leading up to the financial crisis of 2008, it is difficult to see how a new regulatory framework is going to solve this fundamental issue. 

Mr Tyrie cites the mis-selling of PPI and endowment mortgages as two examples of “spectacular” regulatory failures.  That is easy to say with the benefit of hindsight.  Whilst is clear that PPI policies were mis-sold to consumers on an unprecedented scale, this does not mean that they were inherently a bad product.  In many respects it was the pricing structure (and underlying levels of profit for the providers) which meant that it was not sold in appropriate ways to those customers for whom it may have been suitable.  However, neither the FSA, nor any of its successor organisations are meant to act as pricing regulators, and indeed to act as such would stifle the very competitive edge in the UK economy that the FCA is tasked with promoting.

Mr Tyrie’s vehement comments seem to suggest that an effective regulator will be able to keep all of its stakeholders content whilst avoiding all major regulatory “failings”.  If that is his understanding then it demonstrates a lack of understanding of regulatory risk and the challenge of dealing with uncertain events.  In this regard, the influential essayist Nassim Nicholas Taleb identifies ‘black swan’ events as those where: the event is a surprise to the observer; the event has a major impact; and after its first recording, the event is rationalised by hindsight, as if it could have been expected.  These criteria can, and indeed have been, applied to the 2008 financial crisis.  Whilst there is no doubt that a careful and prudential regulator is to be welcomed; there is a danger that apportioning undue blame to the FSA and placing too high an expectation on the FCA will not circumvent future financial crises and  energies are better spent in developing robust regulatory coping strategies and systems, rather than focussing on the regulator.


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