This article was written for and first featured in InCompliance magazine

Peter Wright and James Daughtrey consider whether the FSA’s presence in the boardrooms of authorised firms is a welcome development or an initiative we should be cautious of

As widely reported, it appears that the Financial Services Authority (FSA) has started attending board meetings of some firms that it considers could pose a risk to financial stability in the UK. The move was described by Hector Sants, the Chief Executive of the FSA, as an “eyeball-to-eyeball” approach to regulation. The new approach appears to be part of the regulator’s reaction to well-founded claims that it had too “hands off” an approach to regulation in the years leading up to the financial crisis. So what does the new stance mean in practice and what effects are likely to stem from the change in approach?

Management and corporate governance failings

The failing at some large banks and other institutions in the years leading up to the financial crisis were caused by several factors, one of which was the failure by senior management to correctly assess and, where appropriate, reduce the risks of the firm’s activities on the overall stability of the institution. It can be argued that these failings arose as a result of the culture that prevailed in these firms and the perception that management favoured the growth of their business in a benign climate at the cost of prudence and appropriate risk management.

In order for a firm to operate prudently and effectively it is important that there are effective management and corporate governance structures in place. Dependent on the firm, these structures will include the board (comprising both executive and non-executive directors), asset and liability committees, audit committees and risk committees. However, such structures are only the starting point for effective management and governance. Whilst a firm may have all of the necessary structures in place, it is crucial that those structures work in practice. This is a matter that will very much depend on the action and behaviour of those involved in the board and the other bodies that help govern the firm.

In order to obtain an effective line of sight over systemically important firms it appears attractive to the regulator to participate and monitor such arrangements – but what are the ramifications of such an approach?

So what are the likely effects of board participation?

Draconian move

When compared with previous practice, the FSA’s move to attend board meetings can only be described as a complete change of approach and one which, some might say, is draconian, even in light of the recent turmoil experienced in the UK’s financial system and following the mis-selling of financial products.

Preventing debate

One of the concerns is that the FSA’s presence at board meetings will stymie open and frank debate at board level.

It could be suggested that perhaps directors will end up saying things that they do not really mean, which could cause confusion and mismanagement and ultimately have a negative effect on the outcomes the FSA is trying to achieve.

There is also the risk that board meetings could be “stage managed” for the benefit of the regulator and that the regulator’s presence may encourage more informal decision taking by executives outside of formal boardroom meetings.

Shadow director

One of the most thought-provoking suggestions is that the FSA may end up becoming a “shadow director” of firms. This is perhaps overstated. Under the Companies Act 2006 there is still no statutory guidance to codify the circumstances in which a person will be found to be a shadow director. What the Companies Act 2006 does provide, however, is that a shadow director is a person in accordance with whose directions or instructions the directors of the company are accustomed to act. To become a shadow director, the FSA representative in attendance at board meetings would need to exercise real influence over the company’s affairs and direct the acts of the directors, such that the majority of the board act on such instruction, as a matter of practice, over a relatively long period of time.

Whether the FSA (or its representative) will end up being a shadow director is therefore a question of fact. If the FSA representative is merely overseeing proceedings (perhaps merely to provide a report back to the FSA), then the chance of that person being a shadow director is greatly reduced. It would be stretching the imagination of the Courts to conclude that the presence of the FSA representative has, by virtue of such presence alone, the effect of “instructing” the directors to comply with FSA regulation, as it could properly be argued that the directors are already required to comply with such regulations, whether or not the FSA representative is present at board meetings.

In practice, however, the FSA representative is likely to have a degree of interaction at board meetings. The greater the degree of that interaction, the higher the chances of the FSA being deemed to be a shadow director of the firm concerned. However, whether or not the FSA representative becomes a shadow director is of more concern to the FSA than it is to the firm concerned.

Understanding institutions

One of the benefits of the FSA having a board presence is that the FSA should have a better understanding of institutions. At the very least, if another financial crisis similar to that experienced in 2008-9 were to reoccur, the FSA would have a better handle on the affairs of firms who are caught up in the crisis and it may then be able to respond more effectively (in 2008-9, the FSA’s knowledge of these institutions was so lacking that the FSA was in the end sidelined by government departments such as the Treasury).

Prioritising regulation

It is also probable that FSA presence at directors’ meetings is likely to ensure that regulation gets moved well up the agenda, perhaps in preference to anything else being discussed at the relevant meetings. It must generally be regarded as positive that compliance with regulation is being given greater consideration, as it was relatively ignored in the years leading up to the financial crisis with disastrous consequences.

However, the other side of the coin is that the board may now be distracted from giving due care and consideration to other important non-regulatory matters, such as making a profit (the lack of which can, of course, have its own dire consequences for the firms concerned and the overall stability of the financial system in the UK). One other important observation is that the oversight of regulatory compliance is only worthwhile if the regulations themselves promote the right behaviours, which is a complex debate in itself.

Is an FSA presence likely to achieve its aims?

At present, the FSA’s presence at board meetings has only extended to financial firms which are the “largest” and “most complex” (i.e. most likely banks whose regulation will eventually fall under the remit of the yet-to-be established Prudential Regulatory Authority [PRA]).

However, it is possible that the FSA will, if it has not already done so, start to adopt a similar approach to firms selling financial products to retail customers who will not fall within the remit of the PRA, but nevertheless have a potentially large risk of causing consumer detriment (i.e. those firms that will ultimately be regulated by the Financial Conduct Authority [FCA]).

Despite the risks associated with the FSA’s moves, such an approach could be beneficial for banks and other large financial institutions insofar as it seeks to make the financial system more secure. However, even if the FSA’s presence on the board brings the need for regulatory compliance to the front of directors’ minds, it is likely that many of the things that are now happening would be occurring with or without the presence of the FSA at board meetings.

Regulation has crept up the agenda for good reason and, in the “new” boardroom and regulatory environment that exists today, directors are already focused on capital ratios, the ratio of deposits to lending and so on (profitability has, perhaps, been temporarily relegated now that survival itself appears to at risk).

As for the FSA, a better understanding of firms (something which was profoundly lacking when the recent financial crisis unfolded) will surely assist in the event of another financial crisis. However, there are considerable downsides to adopting such an approach and, whilst it may be appropriate to intervene in the early stage of the aftermath of the financial crisis, the FSA should continue to monitor, on a firm by firm basis, whether such an approach is warranted and proportionate in the months and years ahead.


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