Conclusions and recommendations
1. 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. (Paragraph 15)
The Government's timetable
2. We
welcome the establishment of the Independent Commission on Banking.
The Government should pay full regard to Vickers before coming
to conclusions. Once Vickers has reported it will be equally important
to maintain the political will to act on the Commission recommendations,
if, after scrutiny, action is needed. This has implications for
the timetable for the reforms set out in the current consultation
paper. (Paragraph 23)
3. The Government
needs to take the time required to get its reform of financial
regulation right. We note there was a year between the first publication
of draft clauses on the Financial Services and Markets Bill, and
the appearance of a further draft. Although the Joint Committee
which scrutinised the Bill was given only eight weeks for the
task, it subsequently took from 17 June 1999, when the Bill was
presented in the Commons, to 14 June 2000 to become law. The Bill
was very heavily amended in Committee in response to widespread
criticism after its initial publication. It is one of the longest
and most complex pieces of legislation on the statute books. The
Government's current proposals include a suggestion that FSMA
could be revisited in its entirety. We urge the Government to
ensure that this is done, and present a new Bill only after full
consideration has been given to responses to initial consultation.
Drafting the legislation will then be likely to secure a more
coherent final product and may eventually be quicker, given the
complexities involved in comprehensive amendment of FSMA. (Paragraph
25)
4. The legislation
to establish the new regulatory structure should be subject to
pre-legislative scrutiny, over a reasonable timescale; the eight
weeks allowed for the Joint Committee on the Financial Services
and Markets Bill was inadequate. Even with proper pre-legislative
scrutiny, once introduced, the timetable for the Bill should be
generous enough to allow proper parliamentary consideration, using
carry-over if necessary. (Paragraph 26)
5. However, scrutiny
of the legislation will not be possible without fuller discussion
of what financial stability might look like and how the democratic
responsibilities of government can be combined with the delegation
of significant economic policy making powers to an independent
body. There also needs to be greater clarity about the wider regulatory
framework; the major decisions on the structure of financial regulation
should not be taken until there has been time to consider the
recommendations of the Independent Commission on Banking. Whether
or not it is possible to produce the final legislation within
the two year time frame the Government envisages, the aim of introducing
the legislation in "mid-2011" appears optimistic and,
if pursued too rigidly, runs the risk of compromising its quality.
(Paragraph 27)
6. The FSA will divide
internally, in preparation for the new arrangements. The Bank
of England will continue to publish the Financial Stability Report,
which is likely to be more influential in the interim period.
While the draft legislation is being thought through, clear non-statutory
interim arrangements will need to be in place. The Treasury should
consider the preparation of an Memorandum of Understanding with
the Bank of England and the FSA setting out those arrangements.
(Paragraph 29)
A super regulator—the Bank of England (Paragraph
3)
7. Until
now, such policies have been seen as the responsibility of the
elected Government. If the Financial Policy Committee is to be
given lead responsibility for securing financial stability there
needs to be clarity about what such stability means. The overall
stability of the financial system should certainly not mean that
no firm will ever fail. However, there is room for debate about
how frequent and severe firm failures may be before it is considered
that the system is unstable. Moreover, in the short term, there
could be trade-offs between some types of stability and growth
if, for example, regulation restricts free entry and exit of firms
or discourages innovation in other ways; there are trade-offs
between the stability of the individual firm and growth. Unlike
the MPC, which has a clear inflation target and the well-defined
tool of interest rates and now quantitative easing to achieve
its target, the remit for the FPC is difficult to define rigorously.
Nonetheless, the Government needs to give a view, and a detailed
one, of what the financial stability 'target' should be, how it
should be assessed, and how any trade-offs that financial stability
policy requires are to be managed. (Paragraph 38)
8. The independent
members of the FPC will play a crucial role, at least as important
as that of the equivalent members of the MPC. Given the close
links between the internal members, the external members will
play an essential role in ensuring that the Committee does not
succumb to organisational "groupthink". They will need
adequate support from the Bank. They should be given the right
to commission any information and analysis they feel they need.
(Paragraph 43)
9. Whilst the MPC
has four external members out of a total of nine, the FPC would
have four external members out of eleven. A better balance between
internal and external members of the FPC seems desirable. It could
be achieved by increasing the number of external members on the
FPC, to say six. That would increase the committee's size to thirteen,
so that it would become rather unwieldy. The alternative would
be to reduce the Bank's representation. The Treasury has given
no explanation of the rationale for having Bank executives on
markets and financial stability as full members of the FPC, rather
than non-voting participants, when their respective bosses are
already present, or for including such executives rather than
staff of the PRA. (Paragraph 44)
10. At least some
of the external members of the FPC should have a recent senior
background in the financial services industry. (Paragraph 47)
11. However prestigious
a regulator may be, it will always lose many of its best staff
to the industry it regulates. This is why the experience and credibility
of the external members will be particularly important in ensuring
the success of the FPC, and its credibility in the industry. The
Committee must contain someone with recent experience of risk
management at the highest level from the regulated sector. It
would be wrong to require that the FPC contain members with experience
in particular industries; the task of the FPC is to look at the
financial system as a whole. However there must be no room for
accusations that it is overly focused on banking nor that it lacks
the expertise to look at important sectors, such as insurance.
(Paragraph 49)
12. Conflicts of interest
will be hard to avoid, even if external members have retired from
the industry. They will need to be managed carefully. Some have
made a case for those with current experience serving on the FPC,
and we do not exclude that possibility. However, if the Government
is considering this, it should set out clearly how those conflicts
of interest will be dealt with. (Paragraph 50)
13. The interim FPC
is intended to have an important role in carrying out preparatory
work and analysis for the permanent FPC. Its work may well result
in fine tuning or even substantial amendment of the Government's
proposals. It should be engaged in developing proposals for macro-prudential
tools, and ways in which they might be adjusted. Given that this
body has yet to be established, the current restructuring timetable,
where the new regulatory system will be in place by the end of
2012, may be too challenging. We note that the Government has
been unable to avoid delay on this, despite its desire for speed
and the considerable control it had over this part of the process.
(Paragraph 54)
14. While in the long-term
effective macro-prudential tools should increase economic welfare
overall, particular individuals and companies find their access
to credit affected, even though they are confident they could
service the debt they seek. Many macro-prudential tools are only
now being developed, and their effectiveness will need to be monitored.
As the consultation paper notes, quantitative credit controls,
which were used until the early 1980s, led to distortions. Moreover,
financial innovation can be redirected to get around new regulations.
(Paragraph 65)
15. The Government
has proposed that the tools available to the FPC should be set
out in secondary legislation so that they can be 'fine tuned'
if necessary. Given the impact that the use of macro-prudential
tools may have, we recommend that secondary legislation used to
introduce or alter them require the approval of Parliament. This
raises wider scrutiny issues, to which we shall return. Parliament
needs to assess the nature of the powers which it is to devolve
to the FPC, and the extent to which these can be satisfactorily
encapsulated in legislation. This means that the bulk of the secondary
legislation should be available before the House begins detailed
examination of any Bill. (Paragraph 66)
16. Once appropriate
tools are defined, we understand the rationale for giving the
FPC discretion—in 'peacetime'—on when to use such
tools, without reference to the Treasury. "To take away the
punch bowl just as the party gets going" is easier said than
done: it will be far harder if the FPC first has to identify a
problem and then get the Chancellor to agree to the use of the
tools which might mitigate it. However, only the Government and
the House of Commons have the power to authorise the expenditure
of public money. As we discuss further below, the accountability
issues raised by the Government's proposals are complex, and hard
to resolve and are discussed further in Chapter 9. (Paragraph
67)
17. In its consultation
document, the Government states that "the objectives of price
stability and financial stability should generally be consistent
and complementary". However, in acting to achieve their respective
objectives, the MPC and the FPC will employ tools that may interact
in unexpected ways. These interactions may mean the actions of
one committee could affect the achievement of the other committee's
objective. (Paragraph 72)
18. The Government's
proposals divide responsibility, but address coordination by having
cross membership between the committees. At least three Bank officials
will be members of both committees, giving them immense influence
on monetary and macro-prudential policy making. Given this cadre
of Bank cross-members, ensuring that adequate resources and support
are available to the external members of each committee will be
extremely important. (Paragraph 73)
19. One of the ways
to monitor the influence of the Bank cadre will be through the
transparency of the minutes of the two committees. We will expect
full disclosure of voting within the FPC on the use of the macro-prudential
tools. External members of either committee will always have the
ability to write to this Committee with any concerns they may
have. Other aspects of accountability are discussed in Chapter
9. (Paragraph 74)
20. The consultation
paper proposes "Meetings of the MPC and the FPC will be carefully
sequenced in order to ensure that both committees are able to
fully take into account the most recent decisions of the other."
This presumably means that one committee will not meet until the
minutes of the other have been published. We support this, as
likely to strengthen the position of the independent members.
(Paragraph 75)
21. Cross membership
and sequencing of meetings may be sufficient in times of stability.
However, in crisis periods the committees may need to work together
more closely. Provision for joint MPC/FPC meetings so that policies
on financial stability can be coordinated more effectively may
be required. (Paragraph 76)
22. Risks to financial
stability may evolve, and may change in response to regulation.
We welcome the proposal to give the FPC responsibility for monitoring
the regulatory boundary. (Paragraph 79)
23. The FPC should
also have the power and the responsibility to recommend changes
to the wider legal and regulatory framework, including arrangements
that go across national boundaries, such as those for the resolution
of cross-border banks. Any such recommendations should be copied
to us. (Paragraph 80)
Micro-prudential Regulation
24. Further
consultations should give a fuller explanation of the reasons
for making the PRA a subsidiary of the Bank of England. (Paragraph
86)
25. 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. (Paragraph 89)
26. 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.
(Paragraph 91)
27. 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. (Paragraph
92)
28. 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. (Paragraph 98)
29. 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. (Paragraph 100)
30. The debate about
whether the CPMA should be a consumer champion demonstrates the
importance of making sure that definitions are clear. We have
no doubt that effective conduct regulation should be in consumers'
best interests and will involve a high degree of consumer protection.
Nonetheless, branding the CPMA as a consumer champion would be
inappropriate, confusing, and potentially dangerous. The job of
the regulator is to ensure that regulation is effective and proportionate.
That requires a balance between preventing abusive behaviour and
ensuring that regulation does not impose excessive costs and restrictions,
in order to optimise economic efficiency. Financial markets manage
and price risk; they do not remove it. If a regulator is promoted
as a consumer champion, consumers may falsely believe that all
financial products are risk free, creating moral hazard. It is
simply not possible to protect every interest at all times. We
strongly urge the Government to drop the title of 'consumer champion'
from the CPMA. There are other organisations which campaign for
consumers; the regulator's task is to be alert to abuse, and to
ensure that consumers are appropriately protected in an open and
fair marketplace with the minimum of moral hazard. (Paragraph
110)
31. Competition is
a highly effective means of protecting consumers' interests. The
response given by the Financial Secretary when we pressed him
on whether promoting competition should be treated as a primary
objective for the new authorities was disappointing. The CPMA
should have competition as a primary objective. This will benefit
consumers directly and indirectly. Not only will there be a greater
choice available for consumers, but the transparency which effective
competition brings should reduce the need for heavy-handed regulation.
Greater competition should also help prevent firms becoming too
big to fail. We do not, however, believe that the regulator should
have a remit to facilitate innovation—a properly functioning
market will do that. (Paragraph 118)
32. We have already
proposed that the CPMA should have a primary objective of promoting
competition, and there may be other places where regulators need
a spread of objectives. However, we are unconvinced that 'have
regards' provisions are effective in directing a regulator. The
regulator will have to decide what trade-offs to make when desirable
objectives compete: secondary statutory objectives are likely
to be a more satisfactory way to specify such objectives for all
but the most general provisions. (Paragraph 120)
33. The CPMA will
have a dual remit between consumer protection and markets regulation.
The Government believes that a strong consumer division is required
to deliver protection for consumers, while the industry believes
there is a need for a strong markets division. It has also been
suggested that market supervision might fit more naturally within
the PRA. We urge the Government to give more detail about its
thinking on this subject in the next consultation paper, and,
in particular, what structure it proposes to ensure that both
market regulation and consumer matters receive the attention they
need. (Paragraph 123)
34. We welcome the
Government's decision to put the UK Listing Authority in the CPMA,
rather than splitting responsibility for markets regulation between
three bodies, as first proposed. However, there are still issues
to be resolved, such as the concern about the UK's corporate governance
position within Europe, where the CPMA will represent the UK in
the European Securities and Markets Authority, although many corporate
governance issues remain with the Financial Reporting Council.
The success of the London markets underpins the success of the
United Kingdom financial services industry; the markets division
within CPMA must be adequately resourced, and may need a wider
focus than pure conduct of business. (Paragraph 128)
35. In principle the
consequences of financial crises could pose more threats to consumers
than individual cases of detriment. However, if the new arrangements
work properly, choices between financial stability and consumer
protection should be rare. If the FPC and PRA can produce a system
in which companies can fail without financial instability, then
CPMA decisions should not pose systemic risk. We welcome the Treasury's
reassurance that the PRA's veto over the CPMA can only be used
as a last resort. To ensure that this is so, cases when the power
is exercised should be made public. It may not be possible to
do so immediately, without threatening stability. In such circumstances
the authorities should write to the Chancellor in confidence to
notify him, explaining the reasons that the two authorities differed.
We expect almost all such reports to be made public at the earliest
opportunity, recognising that there may be exceptional circumstances.
In such cases arrangements should be made to inform the Chair
of this Committee. (Paragraph 133)
36. It is important
that the PRA and CPMA work closely together on both prudential
and conduct of business issues; the absence of a Chief Executive
designate of the CPMA risks regulatory thinking being developed
only by those responsible for the parts of the regulatory structure
which are or will be directly related to the Bank of England.
We are likely to return to the relationship between the CPMA and
the Bank of England in future work. (Paragraph 134)
Cost of regulation
37. Given
the urgency of the Government's reform programme and the resources
and time needed to produce a further full study of the costs of
regulation, it will be impractical for the FSA to devote resources
to such a review at this stage. Once the new architecture has
been set up, we recommend that the PRA and the CPMA revisit the
whole issue of cost of regulation, in the light of the financial
crisis and the changes in regulatory structure. (Paragraph 140)
38. Under FSMA, the
FSA is required to undertake a cost-benefit analysis of any proposed
regulatory changes. However, the full costs—always ultimately
borne by consumers—need to be shown. Cost-benefit analysis
must be improved within the PRA and the CPMA. New regulatory requirements
should only be introduced if a full cost-benefit analysis has
been conducted. The authorities also need to be certain and demonstrate
that the benefits are justified by any additional costs to consumers
that might be caused by restrictions to competition. (Paragraph
141)
39. We are unconvinced
by the Financial Secretary's explanation that the £50m transition
costs will be borne by the industry alone. His contention that
a competitive market means that the industry will not be able
to pass on the costs to consumers begs the question as to the
degree of competitiveness in the market. We urge the Treasury
to give more detail about the assumptions underlying the £50m
transition cost. It should also report regularly over the transition
period on the level of actual costs being incurred. (Paragraph
144)
40. We appreciate
the importance of avoiding the regulatory underlap that we have
seen under the Tripartite system. However, removing the underlap
should not result in an overlap of responsibilities between the
new bodies. Overlap, like underlap, can lead to confusion and
paralysis. Careful planning and consideration needs to be given
to the remits and boundary of responsibilities, especially between
the PRA and CPMA. (Paragraph 147)
41. The move to new
regulatory arrangements should be accompanied by better analysis
of the cost of regulation, both one-off and ongoing, for all kinds
of financial firms, by sector and by size. The aim should be to
produce a better, more effective and more cost efficient regulatory
system. (Paragraph 148)
International regulation
42. Effective
participation in international regulation is both a central part
of macro-prudential policy and key to ensuring that micro-prudential
policy can be conducted effectively. (Paragraph 150)
43. Implementing the
G20 priorities alone will place a heavy legislative burden on
the EU. The lion's share of action will need to be taken at a
global level if it is to be effective. The economic welfare added
by regional action therefore requires particularly careful scrutiny.
We are concerned about the scale of the EU agenda, particularly
given that the European Supervisory Authorities, which should
at least be able to help the Commission prioritise its work, have
only just been established. The focus of European effort should
be on explicit commitments by the G20 for reform. These should
be implemented in close cooperation and after careful consultation
with other jurisdictions. (Paragraph 158)
44. If the European
Supervisory Authorities focus on improving coordination between
regulators, and drawing up technical standards which are based
on a deep understanding of the markets regulators have to deal
with, they can add value. However we are concerned at the sheer
scale and pace of the reforms taking place at European level.
The Commission needs to ensure its reforms are technically sound,
and only brought forward after consultation. It also needs to
avoid the danger that political pressure may lead to poor regulation.
Inappropriate regulation will not only damage the United Kingdom,
but the European Union as a whole.
45. It is important
that the UK, with a particularly large share of the financial
services activity of the EU, secures appropriate representation
on the EU regulatory bodies. (Paragraph 169)
46. The establishment
of the ESAs means the Government and the FSA need to treat engagement
in European negotiations as a high priority. The United Kingdom's
regulatory framework must be designed to ensure that engagement
with Europe is effective. (Paragraph 170)
47. At national level
the Government is proposing to devolve a great deal of power to
independent regulators. We do not oppose this, but many of the
actions to prevent a recurrence of the crisis depend on actions
which must be negotiated at an international level. Both the regulators
and the Government may be involved in such negotiations. There
are two potential dangers. The first is that international regulation
becomes the preserve of technocrats, and Governments may become
dangerously disengaged. The second is that political pressure
results in bad regulation. The Government should provide greater
clarity about the way in which negotiations will be handled and
co-ordinated, what role the Government will play, and how it proposes
to minimise these risks. (Paragraph 172)
Responsibilities in times of crisis?
48. We
have some doubts about a system in which one authority decides
whether or not to put an institution into resolution, another
related institution decides what form that such a resolution arrangement
should take and a third is responsible for the decision to use
public funds. We also note that the decision to allow an individual
firm to fail might contribute to a systemic loss in confidence.
(Paragraph 179)
49. We accept that
the Governor will keep the Chancellor up-to-date with developments
in the markets which may have an impact on financial stability.
However, if a systemic crisis occurs which the Bank considers
public money is required to resolve, it is hard to see how the
Government could assess such a request while remaining at arm's
length from the process. As we have seen recently, rescuing the
financial system may have significant effects on public finances.
Only a democratically elected Government should make such decisions.
It will bear the responsibility for any errors; it must have the
information and freedom it needs to choose its position. In times
of crisis, it has to be the Government that is in charge. Once
it appears likely that intervention beyond a single firm is necessary,
and where public funds are put at risk the authorities should
take decisions together, led by Treasury Ministers, and where
appropriate, the Chancellor, chairing any crisis management meetings.
(Paragraph 181)
50. The boundary between
'emerging risks' and 'crisis mode' is often unclear. As we saw
in the banking crisis, major financial institutions, such as RBS
and HBOS, had to be rescued over a short time frame, such as a
weekend. There has to be some mechanism that will allow the Government
to intervene if, in its view, a crisis is developing, and other
authorities are unwilling to act. (Paragraph 183)
51. Despite granting
the Bank of England independence in monetary policy, the Treasury
retains an emergency power to give the Bank directions in setting
monetary policies, when it considers it is in the public interest
to do so and under extreme economic circumstances. A similar 'reserve
power' should be given in the new legislation. It is important
that the Government retains the power to take control over actions
for which it will ultimately be held responsible whilst recognising
that the use of such draconian powers would be an extreme step
and would prejudice the perceived independence of the regulatory
institutions. (Paragraph 184)
Transparency and accountability of the new bodies
52. The
Monetary Policy Committee and the Bank of England have repeatedly
demonstrated their commitment to transparency. They have seen
their engagement with the Treasury Committee as a means of securing
accountability. That has been a key reason for the system's success
and we warmly welcome it. (Paragraph 189)
53. The performance
of the inflation targeting regime in the UK is measurable, with
explicit and well-defined roles for the Treasury and the Monetary
Policy Committee of the Bank of England as to overall policy remit,
decision taking and implementation. Deviations from the target
are obvious, to both the participants, and the wider public. By
a one person, one vote system on the MPC, alongside vote publication
in the minutes, decision making is transparent. The Treasury Committee
takes an active part in this process, pursuing both transparency
and accountability, using our hearings to draw out MPC members'
thinking on key topics, and appointment hearings to assess their
competence and independence. We can also question the Chancellor
as to the remit set by the Treasury for the MPC. Independence
is maintained by the strict separation between remit setting at
the Treasury, and decision making over interest rates at the MPC.
(Paragraph 196)
54. The Treasury and
the FPC must provide far more detailed criteria against which
the achievements of the new regime can be assessed. Without this
accountability will be considerably weakened. (Paragraph 197)
55. The MPC is given
its target in a regular, published remit letter from the Treasury.
We recommend that this be the case for the FPC. We would not be
surprised if the remit changed as more information and further
research becomes available about the operation of the macro-prudential
tools, and about how financial stability can usefully be defined.
Such remit letters provide the political authority for the operation
of such independent bodies. Their publication allows for scrutiny
by this Committee, as well as other interested parties. We will
take a close interest in the Financial Policy Committee, and its
relations with government, and we will hold regular hearings.
(Paragraph 199)
56. The Committee
will give further consideration to the accountability of the new
regulatory structure in the light of the Government's second consultation
document, due to be published shortly. Meaningful proposals on
accountability cannot be made without more detail. (Paragraph
201)
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