House of Commons - Financial Regulation: a preliminary consideration of the Government's proposals

Financial Regulation: a preliminary consideration of the Government's proposals - Treasury Contents

1 Introduction

Financial regulation - from Tripartite to 'Twin-peaks'

1. In July 2010, the Treasury published a consultation document, A new approach to financial regulation: judgement, focus and stability, proposing changes to financial regulation in the United Kingdom.[2] The Government proposes to do away with the tripartite system, in which the Treasury, the Bank of England, and the Financial Services Authority work together. Instead, the Government is consulting on:

giving the Bank of England powers over macro prudential regulation through a newly established Financial Policy Committee (FPC),

and creating:

A new prudential regulator under the control of the Bank of England [...] which will be responsible for supervising the safety and soundness of individual financial firms.

A new Consumer Protection and Markets Authority (CPMA) to act as a single integrated regulator focussed on conduct in financial markets.[3]

The new regulatory framework will follow a 'twin-peaks' model, in which prudential regulation of financial institutions is separated from the oversight of consumer protection and markets conduct.

2. The reforms are intended, among other things, to deal with the problems of the tripartite system. In the aftermath of the collapse of Northern Rock, the then Treasury Committee concluded:

we are concerned that, to outside observers, the Tripartite authorities did not seem to have a clear leadership structure. We recommend that the creation of such an authoritative structure must be part of the reforms for handling future financial crises.[4]

The system was amended somewhat after the Committee's report, but the basic structure remained.

3. The Government's proposals go further than simply dividing prudential regulation and conduct of business regulation between two regulators. They would create a macro-prudential regulator with wide, as yet undefined, power to intervene not only in the affairs of individual institutions, but to take action system wide. The consultation paper states:

Domestically, a major deficiency in the UK's tripartite system has been precisely that no authority had clear, overall responsibility for identifying, monitoring and responding to risks building up and fault lines in the system as a whole. While recent attempts have been made to fill this gap by providing statutory objectives for financial stability to the Bank, and latterly, to the FSA, these changes assigned responsibility without appropriate powers, and entrenched rather than addressed the fundamental problem.

The Government will therefore legislate to put the Bank of England in charge of macro-prudential regulation, by creating a strong Financial Policy Committee (FPC) within the Bank, with ultimate authority to identify imbalances, risks and vulnerabilities in the financial system and take decisive action to mitigate these in order to protect the wider economy.[5]

4. There will be three major bodies. The Financial Policy Committee (FPC), to be created within the Bank of England, and chaired by the Governor, will have "primary statutory responsibility for maintaining financial stability". A Prudential Regulation Authority (PRA) "will be responsible for prudential regulation of all deposit-taking institutions, insurers and investment banks."[6] As well as being a subsidiary of the Bank, the PRA will have strong working links with it: its board will be chaired by the Governor, and the PRA Chief Executive will be a Deputy Governor of the Bank. The Consumer Protection and Markets Authority (CPMA) will have "a primary statutory responsibility to promote confidence in financial markets".[7] The CPMA will be a freestanding organisation, but with strong links to the other regulators: its Chief Executive will sit on the FPC and the regulators will have statutory duties to consult one another.

The financial services industry

5. The UK financial sector was estimated to have contributed about 10% of GDP in 2009, and employed around 993,000 people as of June 2010.[8] It is a diverse industry which includes banking, insurance, securities dealing, and fund management. Regulatory changes can have significant impacts, both on individual firms and on the efficiency of the UK financial industry as a whole. The challenge will be to produce a regulatory structure which reduces the systemic risks financial services pose while ensuring economically advantageous activity is not driven out by inappropriate regulation. Good regulation can provide competitive advantage, as many of our witnesses told us. For example, a home regulator can provide standards which are accepted throughout the world. Mr Abbott, CEO of the London Metal Exchange noted that:

90%-plus of all of the metal futures trading in the world [...] takes place here in London. [...] Therefore, the regulation of the LME takes place here in London by the FSA. We are subject to regulation in other jurisdictions around the globe. We are approved, for instance, in North America by CFTC; also in jurisdictions such as Singapore, Hong Kong, Australia. They accept that the best regulator to regulate any business is the home regulator [...][9]

6. The banking industry is the largest segment in financial services, with over 400,000 employees. However, other sectors within the financial services industry also contribute significantly to the economy:

the UK insurance industry is the largest in Europe and third largest in the world, with insurance premiums collected reaching almost £200bn in 2009;
the London equity market had a global share of 17% in 2009, second only to New York;
the UK fund management industry is one of the largest in the world, with assets under management reaching £4.1tn in 2009.[10]

The sector is estimated to have been the largest payer of corporation taxes in 2010 and accounted for 11.2% of total tax receipts for the year.[11]

7. The Government has said that it intends to bring in a Bill on its proposals by "mid-2011", with an intermediate consultation on more detailed proposals early in 2011.[12] Given this timetable, the importance of the sector, both as a direct and indirect influence on the United Kingdom economy, and the potential impact of the changes, we made it a priority to provide a preliminary examination of the Government's initial proposals. The Committee intends to return to a number of these key issues in the light of the findings of the Independent Commission on Banking. We have not attempted to respond to each of the consultation questions: rather we have identified areas where the Government may need to reconsider, or at least give a fuller account of its reasoning. The Government's proposals are evolving, and we expect to return to this matter again during this Parliament.

Conduct of the inquiry

8. We thought it was important to gather the widest range of views possible on the Government's proposals, and to hear from many different sectors. Accordingly, our inquiry spanned 18 oral evidence panels, taking place from July to November 2010. A full list of witnesses is given at pages 81-3. We are grateful to our many witnesses for sharing their views on this important subject with the Committee. We are also grateful to those who submitted written evidence and to our specialist advisers, Bill Allen, Alex Bowen, John Tiner and Professor Geoffrey Wood.[13]

Overview

9. There have been large costs from the crisis, both to the taxpayer and the wider economy. On top of this, the taxpayer remains exposed to potential loss through the shareholdings it retains in banks such as Lloyds Banking Group or Royal Bank of Scotland (RBS) and through the Asset Protection Scheme. In a speech in November 2009, Andrew Haldane, Executive Director for Financial Stability at the Bank of England, suggested that the support packages provided by Governments and central banks amounted to 74% and 73% of GDP in the UK and US respectively.[14]

10. The costs of the crisis to the wider world economy were significant as well. In a speech in March 2010, Mr Haldane noted that "World output in 2009 is expected to have been around 6.5% lower than its counterfactual path in the absence of crisis".[15] This cost, borne by taxpayers at home and abroad, as well as those directly affected by the financial crisis, carries a significant lesson. Failure of financial services companies can have effects which reach far beyond the companies involved. Mr Haldane outlines the problem, and potential government action:

The banking industry is [...] a pollutant. Systemic risk is a noxious by-product. Banking benefits those producing and consuming financial services—the private benefits for bank employees, depositors, borrowers and investors. But it also risks endangering innocent bystanders within the wider economy—the social costs to the general public from banking crises.[16]

11. Against this background, the Government's desire for urgent action to strengthen the regulatory system is understandable. However, the speed with which its consultation was prepared and published has meant that, although the Government has described the regulatory structures which it wishes to put in place, and their broad objective—the new regulators will pursue 'financial stability'—there are many places where more explanation is essential. In its report on Financial Stability and Transparency, published in 2008, the Treasury Committee noted "There is a continuing lack of clarity about what is meant by financial stability as well as what events constitute a 'serious threat to financial stability'".[17] The new Government now needs to define what it considers financial stability to be. As we will explore throughout this Report, at this stage there is more clarity about the regulatory architecture than the detailed outcomes the Government wishes to achieve.

It's not all about banking

12. The consultation has been criticised for an overemphasis on the banking sector, which may be the result of the speed with which these reforms have been worked out. The banking crisis demonstrated the need to reform bank regulation. Bank activities have been the source of financial instability in the past, and are clearly continuing sources of risk, given their activities in maturity transformation, their use of leverage, and the interconnectedness of their activities. However we heard that regulatory reforms which focus too much on banks may adversely affect other areas of financial activity.[18] To give one example, the Government's proposal to set up two new regulators, the PRA and CPMA, may lead to confusion about which firms will be regulated, or part-regulated, by which regulator. Under the proposals, all banks (including building societies and credit unions), broker-dealers (including investment banks) and insurers will be regulated by the PRA, while the CPMA will pick up the rest of the financial sector, including the conduct of business regulation of any PRA-regulated firms.

13. The split in responsibility between the PRA and CPMA may not be clear in some cases. Whilst most banks will be prudentially regulated by the PRA and by the CPMA on conduct of business, regulation of the non-banks is less clear. For example, most large insurance firms would have asset management arms. Under the new structure, it is not clear whether the PRA or CPMA will be the lead regulator for such organisations. Aviva told us:

no single body will be charged with taking a holistic view of the whole Aviva group. Under the proposed new structure, supervisors would have to gain such an overview despite the fact that substantial businesses within the Aviva group would be subject to prudential supervision by different regulatory bodies: the insurance business by the Prudential Regulatory Authority (PRA), and Aviva Investors (our asset management business) by the Consumer Protection & Markets Authority (CPMA).[19]

14. Furthermore, the proposed structure could cause problems for asset management firms associated with deposit-taking activities. Blackrock told us:

Some asset managers may have entities within their group in the United Kingdom which have permissions as a deposit-taker for insurance business only [...]. It is unclear from the consultation whether these permissions will bring some or all of asset management group entities in the United Kingdom within the scope of prudential regulation by the PRA and conduct regulation by the CPMA or whether it is intended that these activities would be excluded from the scope of the PRA.[20]

15. There are other areas within the financial sector which merit more focus than the consultation paper gave them. Lloyd's, the specialist insurance market with more than £22bn of premium income in 2009, was hardly mentioned in the document. Lord Myners described the consideration given to regulation of Lloyd's as an "afterthought":

It really does appear right at the end of this document. Lloyd's is a significant market. It has been very well regulated, very well run and has produced large tax revenues and large employment in the UK. It is almost an afterthought in this document. We need to make sure that this structure does not in any way disadvantage the UK as a centre for insurance and reinsurance.[21]

We are concerned that the current proposals for reform say relatively little about some key segments of the UK financial sector. Inappropriate regulation of non-banking sectors could cause serious and unintended damage to companies within those sectors, and to the UK more widely. As the Treasury's consultation evolves, it is important that the Government clarifies the regulatory impact of its proposals on the non-bank sectors.

2 Cm 7874 Back

3 HM Treasury Press Notice, 32/10. 26 July 2010 Back

4 Fifth Report of Session 2007-8, The run on the rock, HC 56-I, para 284 Back

5 Cm 7874, paras 2.8-2.9 Back

6 Cm 7874, para 1.14 Back

7 Cm 7874, para 1.21 Back

8 Financial Markets in the UK November 2010, TheCity UK; estimates of the contribution of financial services to the UK economy are however not straight forward. Back

9 Oral evidence taken before the Committee on 2 December 2010, European Financial Regulation, HC 658-i Q 15 Back

10 All data comes from Financial Markets in the UK - November 2010, TheCityUK Back

11 PricewaterhouseCoopers, The Total Tax Contribution of UK Financial Services,Report prepared for the City of London Corporation, December 2010) Back

12 Cm 7874, 7.12, 1.26 Back

13 Relevant Interests of the specialist advisers are as follows (a complete list of interests is published in the formal minutes available on the Committee's website):