Written evidence submitted by the Financial
Services Authority (FSA)
1. We are submitting this memorandum as
part of the Committee's inquiry into the Government's proposals
to change the system of UK financial regulation and in advance
of our evidence session on 23 November. In line with our practice
of not publicly commenting on Government consultation documents
to which we have contributed to, we do not propose to comment
on the proposals as a whole. This memorandum, however, highlights
how the FSA is preparing to implement the proposals and sets out
our assessment of the principal implementation risks and our proposed
mitigations, along with the key risks and opportunities arising
from the new structure.
2. The following sections cover:
— the high level process we have put in
place in response to the Government's proposals;
— the principal risks arising from the
transition to the new structure; and
— the regulatory risks and opportunities
associated with the long term regime.
PROCESS
3. We have established a regulatory reform
programme, led by the FSA Executive Committee, which is working
with the Bank of England and HM Treasury to design the regulatory
and operating model for the new authorities and manage the transition
to the new structure. The expectation is that the cutover will
occur in mid-2012. However, in order to minimise the risk of staff
losses, we plan to move in early 2011 to a shadow split (reflecting
the mandates of the "Prudential Regulation Authority"
and "Consumer Protection and Markets Authority") within
the FSA for our current risk and supervisory functions in early
2011. This will also allow us to modify the operational aspects
of the new approach before its formal launch in 2012. The FSA
will be responsible for operating the shadow split but in designing
the interim structure is consulting with Bank of England to ensure
maximum continuity. The final design of the PRA will be a joint
decision with the Bank of England.
RISKS ASSOCIATED
WITH TRANSITIONING
TO THE
NEW STRUCTURE
4. Executing the de-merger of the FSA is
a complex and resource-intensive exercise with a significant execution
risk. At the high level, the principal challenges to successful
execution are:
— People retention risk: the uncertainty
created by moving to the new structure for individuals is undoubtedly
posing retention and recruitment problems.
— De-merger process: in addition
to the people retention risk it should be recognised that the
actual activity of identifying and matching approximately 4,000
staff to new roles for the new agencies is complex and potentially
disruptive.
— Personnel stretch and its impact on
ability of the FSA to discharge its Financial Services and Markets
Act (FSMA) obligations: the requirement to manage the transition
places considerable pressures which self evidently reduces management
and staff time available for discharging the statutory obligations
of the FSA.
— Continuity of the regulatory interface
with firms: the de-merger carries the risk of a break of continuity
of experience and dialogue with the firms.
— Requirement for new supervisory processes:
the new regulatory structure requires a complete redesign of the
underlying processes which support our supervisory activities.
For example:
(a) ARROW (the FSA's supervisory risk framework)
is fully integrated and will need to be sub-divided for the two
new agencies.
(b) A particular challenge in the design process
is identifying and defining mechanisms to deal with those issues
which clearly span both prudential and conduct regulation, for
example with-profits issues in insurance.
(c) The authorisation process, which is currently
a unified one, will be split to allow each individual agency to
take responsibility for its own authorisation decisions.
5. We highlight below the mitigating measures
we are taking in relation to each of these issues.
6. People retention risk: risks
in relation to staff retention, recruitment and stretch often
arise during any major organisational change. Our overall turnover
was 7.6% at end August this year,[34]
which although low by financial services standards, is the highest
turnover at the FSA since January 2009. The FSA is also facing
retention pressures in key skills areas, for example, some areas
within the Risk Business Unit currently have turnover levels at
16%. This is a function both of a recovery in demand for specialist
skills in the market place as a whole, along with the impact of
increased staff uncertainty arising from the reorganisation. Our
key mitigation in response to increased turnover focuses on increased
recruitment activity and re-allocating staff where possible; we
will also look to increase our use of external contractors if
necessary. In appropriate cases, we are considering retention
payments and/or salary increases, based on competitive benchmarking,
to ensure we are able to retain critical skills needed to achieve
our business goals and/or to ensure we can replace vacated roles.
7. De-merger process: we are seeking
to mitigate the de-merger execution risks by our two stage process
of moving to the shadow structure before the actual transfer of
staff. In executing this approach we are working with external
consultants to seek to identify the best possible method for balancing
the requirements of fairness to staff, continuity for staff but
also ensuring skills are best matched to the new roles. To further
minimise the disruption risk we are seeking to "lift and
shift" those FSA divisions which clearly relate exclusively
to either PRA or CPMA functions without significant change. However,
given that we currently operate an integrated model of supervision
this will not be possible in many cases: our supervisory teams
combine prudential and conduct of business activities, with individual
supervisors included in both.
8. Personnel stretch and its impact
on ability of the FSA to discharge its FSMA obligations: as
we move further in to the design and transition arrangements,
there is an increased need for management time and focus to shape
and implement the shadow structure, in particular spending more
time with the staff. These additional demands on management time
will mean that the FSA will be at risk of not delivering the same
level of supervisory work as it currently does. We believe, however,
that through a structured re-prioritisation process we can minimise
the impact of this risk, but inevitably the amount of time spent
on pre-emptive routine supervision will decline over the transition
period. Additionally, the pressure on senior management time will
reduce our ability to influence developments at the European level.
9. Continuity of the regulatory interface
with firms: the transition to the new structure will necessarily
involve a change in the manner of our dealing with firms and potentially
also in the composition of the supervision teams. This in turn
carries the risk of a break in continuity of experience, dialogue
and knowledge, and therefore a reduction in the effectiveness
of the engagement with the firms until the level of relationship
and regulatory knowledge can be rebuilt. The earlier move to a
shadow structure within the FSA provides a mechanism for mitigating
this risk since we will still have common knowledge and the ability
to support each other.
10. Requirement for new supervisory
processes: we have set up a separate design team staffed by
experienced individuals from the FSA and the Bank of England to
design the new operating model. We have also studied best practice
in other comparable overseas regulators. Critically, however,
wherever possible we will seek to build on our intensive and intrusive
supervisory model that has been introduced in the last few years
for both conduct and prudential supervision. The two phase approach
will also allow us to modify the process in light of the experience
gained from the gradual introduction for the new regime. The new
regulatory model will require a number of changes to the current
FSMA model and we are engaging with HM Treasury to ensure these
issues are fully considered.
11. We will seek to mitigate all these risks
by carrying out phase one of an interim structure as quickly as
possible, thus minimising the time period where management resources
are thinly stretched and staff anxiety at its highest. Furthermore,
we will use external consultants in some cases rather than internal
management resources and as far as possible allocate dedicated
staff to manage the change, allowing other staff to concentrate
on their supervisory role. We have also significantly increased
our level of communication and engagement with staff to help manage
the uncertainty that any change generates, and to communicate
the opportunities that the new structure provides for them.
OPPORTUNITIES CREATED
BY THE
NEW REGIME
12. We consider there to be both opportunities
and risks arising from the long term regime for financial regulation.
As we have previously discussed in earlier FSA publications, the
principal benefit from the proposals is the creation of a comprehensive
and clear framework, led by the Bank of England, for addressing
macro-prudential issues. The new structure of a Financial Policy
Committee (with responsibility for macro-prudential analysis and
policy and the necessary authority over the micro-prudential authority
to ensure effective implementation of that policy), will undoubtedly
address the previously identified gap in the UK regulatory architecture.
The UK will also benefit from the fact that this structure will
allow the central bank and the micro-prudential supervisor to
speak in a fully coordinated manner in international and European
prudential fora.
13. We can also envisage that separate objectives
for the PRA and CPMA will create a narrower specialised focus
and fewer internal resourcing conflicts.
14. The Government's plans additionally,
and importantly, provide the opportunity to build on the far-reaching
improvements that the FSA has been making to its approach to conduct
and prudential supervision and carry these into CPMA and PRA.
There is a particular opportunity to further advance the consumer
protection agenda through the creation of a focused agency which
would certainly benefit from having a wider scope, encompassing
in particular regulation of unsecured consumer credit. The fact
that new legislation is required also creates an opportunity to
improve the regulatory framework particularly with regard to consumer
protection, and the FSA is working closely with HM Treasury to
take advantage of this opportunity.
RISKS ASSOCIATED
WITH NEW
REGIME
(a) Interaction between PRA and CPMA
15. The changes will, as is the case with
any restructure, give rise to regulatory risks which will need
to be addressed over the long term. In moving from an integrated
supervision model to one of "twin peaks", there will
be a loss of the integrated view of a firm and groups whose supervision
is split across PRA and CPMA. The issue is that prudential and
conduct risks are not completely separable since nearly all conduct
risks can potentially generate prudential risks and certainly
in all cases carry information that is relevant to the assessment
of prudential risk. Mis-selling for example can be an indicator
of a poor risk culture and over time can affect the quality of
a firm's asset base. This can be managed by effective co-ordination
between the PRA and CPMA, including through domestic colleges
where appropriate. Information sharing between the two organisations
and cross-representation at Board level, both envisaged in the
Government's consultation, will be key.
16. It is possible that regulatory arbitrage
may arise as firms try to exploit differences in approaches between
the PRA and CPMA. We think that the scope for this will be limited,
given clarity of the boundary between PRA and CPMA. However, it
will be important to keep the boundary under review.
17. We can envisage there being some difficulty
in attracting/retaining specialist prudential expertise in the
CPMA which will continue to have some prudential responsibilities,
for example with regard to asset managers, given the organisation's
conduct focus. This could be mitigated through people strategies
that include initiatives such as secondments between the PRA and
CPMA.
18. As time passes, there is a risk of different
requirements emerging (eg for governance, high level systems and
controls) for firms and individuals that are regulated/authorised
by both the PRA and CPMA. Mitigation will be through close involvement
in respective policy-making functions as well as the cross-representation
at Board level.
(b) European/International
19. With the ever growing importance of
the European regulatory regime and framework, it will be essential
that the PRA and CPMA are able to represent the UK's interests
effectively internationally. The PRA/CPMA split of responsibilities
does not map neatly onto the sectoral split of responsibilities
(into banking, insurance and securities markets) of the new European
Supervisory Authorities (ESAs), which will come into operation
on 1 January 2011, or to the global standard setting committees.
The ESAs will determine the detailed regulatory standards that
will apply in the UK and have a significant say in how cross-border
supervision is conducted.
20. There is thus a risk that the single
UK regulatory voice in some cases is weakened by the fact that
two or more organisations will share the representational role
in the various international regulatory committees. In other cases
(especially in Europe) the UK will only have one vote on each
committee and will need to resolve conflicting objectives and
interests between the various interested UK authorities. This
can be mitigated through clarity in the roles and objectives of,
and effective coordination between the PRA and CPMA. Coordination
will also need to extend to The Pensions Regulator and potentially
other UK authorities.
(c) Markets Oversight
21. In relation to markets oversight, it
is the FSA's view that there are two key design criteria for any
regulatory structure. One is the need to have a clear integrated
oversight of the marketplace; origination, trading, clearing and
settlement. The second is ensuring that the UK's representation
in European and international fora is as clear, coherent and strong
as possible. This is particularly important in relation to wholesale
markets issues since, as noted above, the new European Supervisory
Markets Authority (ESMA) will have significantly increased powers
over UK-based activities. The UK only has one seat in ESMA and,
as the Government's proposals note, this will need to be filled
by the Markets component of CPMA. The Markets component of CPMA
must therefore have the greatest possible credibility and influence
both domestically and internationally, and have the capacity to
attract high quality staff. The comments in the Government's consultation
document about achieving this are most welcome.
22. However, one version of the structure
proposed in the consultation document would if implemented divide
the responsibilities further, potentially creating a new "tripartite"
for markets regulation consisting of the Financial Reporting Council
(primary markets regulation), the CPMA (secondary markets regulation),
and the Bank of England (post trade regulation).
23. This division of responsibilities within
the UK would create a highly fragmented representation in European
and international fora. This risk could be mitigated through a
set of coordinating mechanisms defined through MoUs, but any multi-agency
structure carries greater coordination risk than a unitary one.
24. A separate risk in this proposed new
structure would be the separation of primary markets regulation
(UK Listings Authority (UKLA)) from secondary markets regulation
(CMPA). No other major EU countries separate primary and secondary
markets regulation because coherence between the two is essential
for an effective running marketplace. The coordinating mechanisms
required between the CPMA and FRC would need to reflect that the
UKLA is not simply a companies information regulator but a securities
markets regulator for all securities (only 6% of securities relate
to UK companies equity). The UKLA is one key component in the
chain of real-time markets surveillance—consisting of: monitoring
the conduct of issuing firms (and the sponsoring investment banks);
supervising the infrastructure on which trading takes place; and
taking enforcement action under the market abuse regime. Effective
market regulation requires oversight of the entire transaction
chain.
(d) Enforcement
25. The Government consultation document
recognises that the CPMA will be responsible for the enforcement
of its conduct rules in relation both to consumer protection and
market integrity. It also makes reference to a subsequent consultation
on the creation of an Economic Crime Agency and the question of
whether responsibility for prosecuting certain offences should
be transferred to a new agency. We believe it is critical that
the CPMA maintains a strong and effective enforcement function
with broad powers, including criminal prosecution to deal with
insider dealing and market abuse. The FSA currently operates a
fully integrated model and the success of the credible deterrence
strategy over the last three years demonstrates that this has
been highly successful. Any move away from this approach would
thus carry the risk of undermining the CPMA's ability to achieve
its goals and the progress made to date. Furthermore, the lack
of clarity on this issue adds further uncertainty which affects
both our planning process and staff retention and recruitment.
CONCLUSION
26. This paper has set out for the Committee
a summary of the implementation risks for the FSA and the mitigating
measures we are taking, along with an overview of the principal
opportunities and risks which we believe the new structure operates.
Our senior management team are fully focused on doing their upmost
to minimise the implementation risks and take advantage of the
opportunities presented to improve regulation in the UK and thus
improve outcomes for consumers and market users.
27 September 2010
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