Select Committee on Treasury Written Evidence

Memorandum from the Financial Services Authority (FSA) and the Financial Services Compensation Scheme (FSCS)

  1.  This is a joint Memorandum by the FSA and the FSCS ahead of our appearance before the Committee on 11 December. The Memorandum covers:

    (a)  the FSA's role in the coming months in supervising Northern Rock, working with the Bank of England and the Treasury;

    (b)  changes that have already been made to deposit protection;

    (c)  the exercises now under way, involving the FSA, the FSCS, the Bank of England and the Treasury, to learn lessons from recent events and to improve the regulatory and compensation arrangements for the future; and

    (d)  further information about the FSCS (included in Annex 1).


  2.  Following the announcement in October of revised Bank of England facilities and the extension of the Treasury guarantee to new retail deposits, the firm is operating in the stabilisation period that extends to February 2008, and is considering its strategic options. The Tripartite Authorities' objectives for any sale or restructure of Northern Rock are set out in their "Statement of Principles for Assessing Proposals", published by the Chancellor on 19 November.

  3.  The Tripartite Authorities are holding regular meetings with the Northern Rock senior management team. The FSA continues to supervise the firm at a much increased level of intensity. (Given current market conditions, we are monitoring all wholesale and retail banks and deposit-taking institutions closely). In parallel, other strands of work are being taken forward by the Bank of England and the Treasury as appropriate.


  4.  The current system for deposit protection operates within the framework established in 2001 under the Financial Services and Markets Act 2000 (FSMA). The FSCS covers customers of all authorised financial services firms, including banks and building societies, for certain regulated activities. The FSA is responsible for setting the rules within which the FSCS operates, including on eligibility of claims and compensation limits. The FSCS is funded through levies on the industry and has the power to issue levies during the financial year if a particular failure or failures make that necessary. The FSCS service is free to consumers at the point of use.

  5.  In 2005 the FSA started to review the funding model for the compensation scheme, and on 14 November 2007 announced the changes it had decided to make. The new model, which will come into effect in April 2008, will increase the financial capacity of the scheme for compensation arising from deposit-takers from £2.7 billion in perpetuity to £4.03 billion annually and will provide consumers with added certainty that valid claims will be paid, according to the limits placed on the amount of compensation payable by the FSCS. It will be a more robust, resilient, efficient and cost-effective scheme.

  6.  In addition to this work which had been in train for some time, in light of recent events, on 1 October this year the FSA increased the FSCS limit for deposits to 100% of the first £35,000 of each depositor's savings, up from the previous limit of £31,700. The previous limit, last confirmed in 2005, was made up of 100% of the first £2000 and 90% of the next £33,000 of depositors' eligible claims.


  7.  We recognise the widespread public concern caused by recent events and we are determined to learn lessons for the future. Some of the work under this heading is for the FSA; many workstreams involve the FSA and the FSCS working with others, including the Bank of England and the Treasury.

  8.  In the FSA's view, recent events confirm the validity of its overall philosophy of principles—and outcome—focused regulation, which seeks to foster innovation and competition. In particular, the FSA believes that recent events reinforce the need to focus supervision work on the outcomes and consequences of management actions, rather than just on a firm's compliance with individual rules. We recognise that a successful financial market place requires innovation and competition; overall, this approach has served the UK economy and its financial markets well. In turn, that means there can and will be failures. However, in the FSA's view a principles-based regime provides the best chance of achieving the necessary balance between the benefits and risks of innovation. The work now under way, described below, is designed to reduce the impact on market confidence of any future failure.

The FSA's Internal Supervisory Review

  9.  The FSA's Director of Internal Audit has now begun a review to ensure that the FSA learns the lessons from the Northern Rock events, including for its risk-assessment and risk-mitigation practices as a whole. The review is examining the supervisory approach adopted for the period 1 January 2005 to 9 August 2007, looking both at Northern Rock and a small sample of other high-impact firms, in order to provide a basis for comparison. Where aspects of relevant regulatory practice or policy are currently already being reviewed or revised, the review team will take account of that work in reaching its own conclusions. The FSA will publish the conclusions of the review in March, following discussion by the February Board. The Terms of Reference for the Review is attached as Annex 2.

The FSA's Liquidity Supervisory Review (national and international)

  10.  The Northern Rock case has also raised questions about the authorities' approach to monitoring banks' liquidity. The FSA and the Bank of England recognise the need to accelerate the work already in progress on modernising the liquidity regime, both domestically and internationally. The FSA will therefore publish a Discussion Paper on liquidity in December. The Paper will assess the effectiveness of the existing FSA liquidity regimes in the light of recent events and will consider the need for change. The Paper will build on UK work begun in early 2007 in discussion with other regulators, under the aegis of the Basel Committee. The FSA will consult publicly for three months and plans to publish a consultation paper with firm proposals in mid-2008.

Tripartite and FSCS work on Banking and Compensation Reform

  11.  Recent events have also raised questions about the adequacy and effectiveness of current arrangements for dealing with banks in distress. In October the Tripartite Authorities set out the main issues in a joint Discussion Paper "Banking reform—protecting depositors". We have now drawn together a number of existing and planned projects to ensure that the framework for dealing with banks in distress, including the framework for compensation work well to protect the interests of depositors and help promote the stability of the financial system.

  12.  The diagram below shows the work that is now under way, summarising the objectives of each workstream:

Banking Reform

  13.  The banking reform project, led by the Tripartite authorities, and working with the FSCS and others, is reviewing the tools available when a bank is in distress, consistent with the aims of providing appropriate consumer protection, whilst maintaining financial stability and ensuring there is an appropriate sharing of costs, with the taxpayer interest protected.

  14.  Work is being taken forward in several areas, each led by the most relevant Tripartite Authority:

    (a)  identifying the areas where we would want to ensure that continuity of banking services is provided;

    (b)  the way the authorities might approach the resolution of a failing or a failed bank, and the powers which the authorities would need to achieve this; and

    (c)  changes that are needed to the compensation framework to ensure that the FSCS can safeguard depositors of failed banks.

Compensation Reform

  15.  In addition, the FSA is pulling together, and in some cases bringing forward, a number of existing or planned FSA workstreams in relation to compensation provision for all UK consumers of financial services. The objectives for this work include: a compensation environment that offers sufficient protection to retail customers; stakeholder confidence in the retail market is maintained; levies raised should be sufficient to meet payments and can be paid in a timely manner; and the scope of the compensation scheme reflects the risks attached to those activities and is in line with EU requirements.

  16.  There are two main workstreams under the heading:

    (a)  Scope, Limits and Operation will look at the scope of the FSCS and at the limits payable for claims from each sector. We have decided to bring this work forward from 2009.

    (b)  Long-term Tariff Reform will review tariff measures still outstanding from the recent FSCS Funding Review, with the aim of designing tariff levels that better reflect the size and amount of business each firm undertakes.


  17.  Since 2001 when it was established, the FSCS has paid about £1 billion in compensation to consumers, including more than £560 million in payments to customers of failed insurance companies. It has handled the failure of firms as diverse as independent financial advisors and credit unions through to insurance providers such as Independent Insurance. Further information is provided in Annex 1.

4 December 2007

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