4 Micro-prudential Regulation
The PRA as a subsidiary of the
Bank of England
81. The daily regulation and supervision of financial
firms, or micro-prudential regulation, will be carried out by
a new Prudential Regulation Authority (PRA). It will be a new
subsidiary of the Bank of England, and will be responsible for
sectors such as deposit-takers, investment banks and insurance
firms. It is anticipated that approximately two thirds of the
existing FSA staff will join the PRA.
82. The PRA will be chaired by the Governor. Hector
Sants, the current Chief Executive at the FSA, will remain to
oversee the transition and will become Chief Executive of the
PRA and a Deputy Governor of the Bank. Andrew Bailey, the Bank's
Chief Cashier, will be Deputy Chief Executive in the new regulator,
and will help with the transition. The Deputy Governor for Financial
Stability (Paul Tucker as it stands) will also sit on the PRA
Board.
Combining financial stability
and micro-prudential regulation
83. The rationale for combining macro- and micro-prudential
supervision is clear. Policy-makers must have an intimate understanding
of how the relevant financial institutions behave and what risks
they run if they are to safeguard the stability of the financial
system as a whole. And changes in the macro-economic environment
affect the risks faced by individual institutions and may warrant
across-the-board changes in the intensity and focus of micro-prudential
supervision. As Clive Briault, the former FSA director of retail
markets, has argued, there are potential synergies with conduct
of business supervision, so the case for separating the 'twin
peaks' is not necessarily watertight .[73]
But the evidence of the recent financial crisis suggests that
mixing functions can contribute to a lack of focus on rising macro-prudential
risk and difficulties in moving to a 'war footing' when that risk
becomes substantial. In addition, the incentives are different.
For example consumer protection can be well served by keeping
a bank open, while stability is well served by closing it.
84. The current proposals combine both aspects of
prudential policy within the monetary policy institution. That
goes beyond the Australian twin peaks arrangement, where Australian
Prudential Regulation Authority (APRA) combines the two aspects
of prudential policy outside the central bank, the Reserve Bank
of Australia (RBA). The reasons for this separation of prudential
regulation from the central bank were:
The combination of deposit taking, insurance and
superannuation regulation is unlikely to be carried out efficiently
and flexibly by a central bank whose primary operational relationships
are with banks alone and whose operational skills and culture
have long been focused on banking;
Separation will clarify that, while the central bank
may still provide support to maintain financial stability, there
is no implied or automatic guarantee of any financial institution
or its promises in the event of insolvency; and
Separation enables both the RBA and APRA to focus
clearly on their primary objectives and will clarify the lines
of accountability for the regulatory task.[74]
The arrangements proposed for the United Kingdom
also differ from the arrangements in countries such as Finland
and France, where the central bank has close connections with
the supervisory authority but no longer has direct and sole responsibility
for monetary policy.
85. Nevertheless, a case can be made for a close
relationship between monetary and prudential policy-makers because
of the impact of a central bank's policy interest rate on financial
conditions and the impact of regulatory tools on the monetary
transmission mechanism. That case is stronger in a setting where
regulatory tools are adjusted more frequently as a means of mitigating
macro-prudential risk, as the reform proposals currently suggest
they will be (although much remains to be done to understand precisely
how changing bank capital ratios and liquidity requirements might
affect the monetary transmission mechanism).
86. That is not, however, the case advanced by the
consultation, which argues that combining prudential regulation
and responsibility for financial stability within a single organisation
means:
There will no longer be a gap in which responsibilities
are unclear, and regulatory powers uncertain. The FPC will be
able, within the remit of macro-prudential policy, to require
the PRA to take regulatory action with respect to all firms.[75]
However, the FPC is to have the authority to direct
the CPMA, which is a free standing organisation. Further
consultations should give a fuller explanation of the reasons
for making the PRA a subsidiary of the Bank of England.
Non-zero failure = regulatory
success?
87. In evidence to us the Governor said:
The purpose of prudential regulation, unlike the
regulation in either market enforcement or consumer protection,
is not about checking whether the individual institution has or
has not done something, will or will not fail, it's about the
risks to the system as a whole. That's the sole purpose of prudential
regulation. We will not be setting out to ensure that institutions
never fail. Institutions will fail. The crucial point, as Paul
[Tucker] said, is that they can fail without causing disruption
to the rest of the system.[76]
During his appearance before the Committee, Hector
Sants concurred:
[The PRA] should not be judged on stopping firms
failing for idiosyncratic reasons, firm-specific reasons: it should
be judged on whether those failures then carried costs to the
system. [...] We are not trying to take idiosyncratic failure
out of the system. If you do that, you do not get innovation and
you do not get economic growth and a vibrant economy. So, the
PRA should be judged by whether it can avoid failure which comes
with a cost to the system, not whether it can avoid failure. Orderly
failure should not be seen as poor performance by the PRA.[77]
88. In a recent speech, Mr Sants has appeared to
move away from this position:
[...] the PRA is likely to spend a relatively higher
proportion of its resources on reducing the impact of firm failure
than the FSA has done, and relatively less on reducing the probability
of failure. Supervision of low-impact firms will likely centre
on resolvability, on monitoring compliance with rules and reacting
to any issues that may arise. This is an extension of the model
currently employed by the FSA for smaller insurers and credit
unions.
In the case of medium-impact firms, the PRA will
also be prepared to tolerate failure. Given the failure of such
firms may have a non-negligible impact on the financial system
(or be resolved at non-negligible cost), the PRA will seek to
reduce both the probability and the impact of failure through
its supervisory strategy.
For high-impact firms, given that—even with
resolution tools—the impact of failure is uncertain, the
PRA will have a low tolerance for such events. It will focus supervisory
resource, particularly senior management resource, on delivering
intensive, intrusive, judgement-based supervision focusing on
issues that really matter to the safety and soundness of the firm.[78]
89. While
there may be circumstances in which public authorities need to
prop up a particular firm to avoid systemic risk, we are concerned
by the implicit acceptance that any failure of a high-impact firm
should be avoided. In
a recent working paper for the Peterson Institute, Nicolas Veron
and Morris Goldstein have identified the following problems if
institutions are "too big to fail" (TBTF):
First, such institutions exacerbate systemic risk
by removing incentives to prudently manage risks and by creating
a massive contingent liability for governments [...]
Second, TBTF institutions distort competition. According
to Moody's, the 50 largest banks in 2009 benefited from an average
three-notch advantage in their credit ratings, which has been
understood to be at least partly related to official support (BIS
2010). [...]
Third, the treatment of TBTF institutions lowers
public trust in the fairness of the system and undermines the
framework of responsibility and accountability that is supposed
to characterize capitalist economies if and indeed when it boils
down to the privatization of gains and socialization of losses.[79]
We note that in its recent financial stability report
the Bank of England identified an implicit subsidy of £100bn
in 2009 for those firms considered too big to fail.[80]
A statement that the regulator will have "low tolerance of
failure" for certain firms both reduces market discipline
on such companies and risks distorting the market further in their
favour.
90. We note that conduct of business issues may on
occasion lead to systemic risk and that the CPMA is also expected
to identify behaviour which may give rise to systemic risk. In
evidence, the Financial Secretary to the Treasury agreed that
the PRA would take a "fairly active supervisory role"
and that he was:
very clear [...] that we want both the PRA and the
CPMA to engage much earlier in the process, to identify risks
at an earlier stage and to be proactive in trying to tackle those
risks.[81]
91. We
are also concerned about the suggestion that the PRA's efforts
will be focused on what it considers to be medium and high-impact
firms. As the case of Northern Rock demonstrated, the failure
of a company which was apparently 'low-impact' engendered a systemic
loss of confidence. The PRA will need to have a strong justification
for reducing the supervisory effort for such 'low-impact' firms.
92. We agree
that regulatory success does not and should not mean that no firm
will fail. The Prudential Regulation Authority's aim should be,
not to prevent firm failure, but to protect taxpayers and the
wider economy from the consequences of such failure. Hector Sants'
suggestion that the PRA will have a low tolerance for the failure
of high impact firms is a source of concern. The assumption that
certain firms cannot be allowed to fail results in market distortion,
entrenches the market power of large incumbents and thereby stifles
competition. That lack of market discipline may, over the long
term, itself engender systemic instability. Although there may
be combinations of circumstances in which individual firms require
support to limit systemic risk, we reiterate our predecessor Committee's
recommendation that no firm should be too important to fail. Competitive
markets need both freedom to exit and freedom to enter.
Away from 'tick-box, light-touch
regulation': a more judgement-led approach
93. The consultation paper notes "The PRA will
be established as a subsidiary of the Bank, so that it will benefit
from the Bank's judgement-driven culture."[82]
Hector Sants has also signalled that the PRA will carry out a
more judgement-led style of prudential regulation than the FSA
used before the crisis.[83]
In effect, this means supervisors spending more time understanding
firms' business models and strategies, and using their judgements
to investigate and tackle risks and vulnerabilities within individual
firms.
94. Making judgements is always difficult, and can
have an element of the subjective. The industry is concerned that
this new regulatory approach will bring uncertainty to firms.
It has also raised concerns whether the existing FSA staff are
equipped to move away from the 'tick-box' approach to exercise
judgements on supervision and making regulatory decisions. The
Financial Services Practitioner Panel told us that 'judgement
led regulation is only acceptable on the basis of clear and transparent
principles which are applied on an equal basis.'[84]
95. AFME agreed that the quality of the supervisors
would be crucial in this judgement-led approach:
[...] the success of more judgement-led regulation
will ultimately rest on the quality and competence of the staff
that take individual, firm-specific decisions. To ensure consistency
and fairness, the authorities will need to have streamlined and
clearly articulated procedures, which are transparent, provide
reasons for a decision and give firms wishing to challenge a decision
a fair hearing.[85]
96. Angela Knight explained the importance of having
the right people:
[...] if you have higher calibre people, higher quality
supervision, you will get a better outcome. Judgements, I think,
do have to be exercised and that means that you need people who
can exercise those judgements. [...] whatever regulatory structure
you have has to be attractive to people as part of their career;
attractive to people of a seniority and of a type that may have
not been attracted certainly in sufficient numbers to the FSA.[86]
97. The Investment Management Association agreed
that "the key to this will be to ensure that only staff with
the highest levels of skills, training and experience—including
experience in the industry—are entrusted with such judgements."[87]
98. Judgement-based
regulation can cover a number of approaches, from challenging
a company about how it would perform under a variety of market
conditions, to substitution of the regulator's judgement for that
of the company management. The aim should be to ensure that companies
can fail without undue adverse impact, rather than to attempt
to second guess management approaches. We are also concerned about
how the PRA will manage situations in which members of the board
of a supervised firm, who have personal legal responsibilities,
do not agree with its judgment.
REGULATION AND AUDITORS
99. Practice Note 19 of the Auditing Practices Board,
dated January 2007 stipulates:
the auditor of a regulated entity should bring information
of which the auditor has become aware in the ordinary course of
performing work undertaken to fulfil the auditor's audit responsibilities
to the attention of the appropriate regulator without delay when:
(a) the auditor concludes that it is relevant
to the regulator's functions having regard to such matters as
may be specified in statute or any related regulations; and
(b) in the auditor's opinion there is reasonable
cause to believe that it is or may be of material significance
to the regulator.[88]
100. The House of Lords Economic Affairs Committee
is currently inquiring into auditors. Amongst its questions is
"Can auditors now contribute to better regulation of banks?"
We note that on 17 January 2011 the Financial Reporting Council
and the FSA agreed a memorandum of understanding on the relationship
between the Audit Inspection Unit of the FRC. It states:
The FSA and AIU will maintain a close working relationship
to deal with relevant issues arising in relation to the conduct
of audits of authorised persons. Those issues include policy issues
and issues arising in relation to particular authorised persons
or their auditors.
The FSA and AIU will meet regularly, and at least
four times a year. The timing of the meetings will be aligned
with their work programmes, to enable them to inform each other
of topics or issues of mutual concern or interest and to enable
them to take account of such discussions in planning their future
work.[89]
We welcome the memorandum of understanding
between the FRC and the FSA on audit. The regulator needs to be
confident that auditors will share their concerns directly and
they should have a duty to do so. The regulator should also be
able to obtain any audit information it needs from the auditors.
73 Briault, Clive (1999): The Rationale for a Single
National Financial Services Regulator 6 (Fin. Servs. Auth.,
Occasional Paper No. 2) Back
74
The integration of financial regulatory authorities - the Australian
experience, Paper presented by Jeremy Cooper, Deputy Chairman
Australian Securities and Investments Commission to the Comissão
de Valores Mobiliários (Securities and Exchange Commission
of Brazil) 30th Anniversary Conference, 'Assessing the Present,
Conceiving the Future' Back
75
Cm 7874, para 1.5 Back
76
Q 779 Back
77
Q 707 Back
78
Reforming regulatory practices: progress to date, Speech
given at Thomson Reuters, 13 Dec 2010, http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2010/1213_hs.shtml Back
79
Peterson Institute for International Economics, Too Big to
Fail: The Transatlantic Debate, Morris Goldstein and Nicolas
Véron, January 2011 Back
80
Table 5.9, Bank of England
Financial Stability report, 17 December 2010 Back
81
Q 866 Back
82
Cm 7874, para 3.29 Back
83
Reforming regulatory practices: progress to date Back
84
Ev 232 Back
85
Ev 212 Back
86
Q 118 Back
87
Ev 209 Back
88
The Auditing Practices Board, Practice Note 19, The Audit of Banks
and Building Societies in the United Kingdom, Revised Back
89
See http://www.frc.org.uk Back
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