Financial Regulation

Written evidence submitted by the Building Societies Association

This document provides written evidence from the BSA to the Treasury Select Committee on its inquiry into financial regulation and the Government proposals for regulatory reform set out in A New Approach to Financial Regulation: Judgment, Focus and Stability.

Summary

The BSA regards the following four points as the most important. The rest of this submission replies individually to the questions asked by the Treasury Select Committee.

The need to build in diversity

In the BSA’s view, the Government was absolutely right (in the Coalition’s programme for Government published in May) to recognise the importance to financial stability of diversity in financial services. Financial stability must be the Financial Policy Committee’s (FPC’s) overriding objective and diversity is integral to achieving this objective.

Diversity also forms an important aspect of a competitive financial services industry (which the Coalition programme pledges to enhance still further). Accordingly, the BSA welcomes the suggestion in paragraph 4.12 that the need to maintain diversity is suitable as a "have regard" for the Consumer Protection and Markets Authority (CPMA).

It is worth noting that, because of one member-one vote, Board members of building societies, including executive directors are directly elected by consumers - in contrast to many other business forms.

The BSA believes that the FPC, the Prudential Regulation Authority (PRA) and the CPMA should each have a specific statutory remit consistent with, and in discharge of, the Government’s policy of encouraging financial diversity. There should be a senior member of staff, in both the PRA and CPMA, with a specific remit of ensuring that diversity, including the particular position of mutuals, is fully taken into account. (See reply below to the following question - will there be unintended consequences of the Government's proposals for regulation on the prospects for non-bank financial institutions?).

The potential complexity and cost of the new arrangements

While the BSA recognises the underlying reasons why the Government has proposed the new regulatory framework, there are (as recognised in the HM Treasury Paper) risks of duplication, overlap, confusion and lack of co-ordination in what is planned. Therefore, it is essential that the practical arrangements are focused in such a way as to avert these potential problems.

It is also possible that, with a number regulators in place of one, regulatory costs will spiral at what is a very bad time for business and the economy. Any increased regulatory burden is likely to be particularly difficult for smaller firms, unless dealt with in a sensible, proportionate manner.

The BSA believes that certain fundamental principles should be established at the outset; namely –

· an overall limit on the overheads and budgets of the new regulators, benchmarked against the existing overheads and budget of the FSA (from which the new regulators will inherit their new functions)

· the sharing by the new regulators of ‘back office’ facilities and services so far as practicable

· the use by the new regulators of a common gateway for firms and others to the new regulators eg for regulatory returns, permissions and approvals etc

· careful planning be undertaken to ensure that the new regulatory burdens do not disproportionately affect smaller firms

· no overlaps between the PRA and CPMA eg on material in discussions and consultations, thematic work, enforcement etc and there should be a senior Treasury official charged with ensuring that, while the regulators must of course actively co-ordinate, they do not allow any drift into a position where their functions overlap

· no substantial changes to the FSA Handbook of Rules and Guidance purely because of the creation of the new regulatory bodies (for the time being, only necessary modifications to accommodate the new regulatory regime, and any sensible simplifications that can be achieved with minimal further disruption), and

· an early resolution of the CPMA’s regulatory approach – will principles-based regulation (PBR) still have a place in the regulator’s approach to conduct of business or will this be swept away by the more intrusive and pre-emptive consumer protection strategy being developed by the FSA?

Beneath their own primary objectives, the FPC, PRA and CPMA should be subject to the same (or as near as possible, the same) range of statutory factors to which they must have regard, including each other’s primary objectives, the importance of diversity in the financial system etc. Such a uniform position would be very much in the interests of consistency.

The CPMA’s role as a consumer champion

It is inappropriate for a conduct of business regulator to be a "consumer champion" - yet this is what the Government proposes. Accordingly, while we fully recognise that the CPMA must, of course, have a fundamental consumer protection objective, we believe that the proposed primary objective for the CPMA should be extended by the addition of the italicised words, as follows –

"ensuring confidence in financial services and markets, with particular focus on protecting consumers and market integrity while acting in a fair, impartial and objective manner towards all interested parties and sectors."

(See reply below to the following question - do the Government's proposals appropriately assign roles and responsibilities between the different regulatory institutions?)

Bank of England and FPC accountability

Taking a broad view of the proposed arrangements, there is a risk of the emergence of an excessively powerful Bank of England unless very robust accountability and transparency provisions are put in place. We welcome the Government’s recognition of the need for strong accountability, but believe that the proposed arrangements could go further, without diminishing (but, indeed, reinforcing) the overriding importance of financial stability. (See reply below to the following question - has enough been done to mitigate the risk of conflict between the FPC and the Monetary Policy Committee (MPC)?)

Introduction

1. The Building Societies Association (BSA) represents mutual lenders and deposit takers in the UK including all 49 UK building societies. Mutual lenders and deposit takers have total assets of over £365 billion and, together with their subsidiaries, hold residential mortgages of almost £235 billion, 19% of the total outstanding in the UK. They hold more than £245 billion of retail deposits, accounting for 21% of all such deposits in the UK. Mutual deposit takers account for about 36% of cash ISA balances. They employ approximately 50,000 full and part-time staff and operate through approximately 2,000 branches.

Will the Government's financial regulation proposals improve the framework for financial stability in the UK? Will they work in a crisis?

2. We believe that they have the potential to deliver improvement and to work in a crisis.

3. If the framework operates as planned, each body would be clear in its fundamental role. Potentially there would be clarity of objectives and a reduced risk of considerable activity in respect of one function (say, conduct of business regulation) camouflaging inadequacies in another (say, prudential regulation of firms). However, along with potential benefits, the new arrangements also carry certain risks (such as increased costs, complexity, overlap, conflict etc). And the contrasting objectives of the PRA and CPMA will externalise conflicts that under the FSA have been managed within a single body. This will give rise to further challenges that will need careful management.

Do the Government's proposals get the balance right between tackling the problems of the last crisis and preparing the UK financial system for the next one?

4. The key strength of the proposed arrangements – as noted above – is that each body would have a clear primary responsibility or objective. If accompanied by proper co-ordination and decisive early action, the new framework has the potential of averting future crises.

5. But the keys to preventing further serious problems are (i) sound business plans properly carried forward and (ii) effective regulation in practice (the two elements absent, for example, from the Northern Rock crisis and from other business and regulatory failures) – nearly everything else is damage limitation. However many safeguarding procedures are put in place, there is unlikely to be a serious regulatory bulwark against financial instability unless the relevant authorities are fully committed in practice to carrying out their functions effectively.

6. Of course, no-one knows the nature of the next crisis, so it is difficult to be certain whether the new framework will be adequate in responding to the nature of that crisis.

How do the Government's proposals dovetail with initiatives currently being undertaken at European and the global level?

7. We welcome the Government’s recognition (in paragraph 1.12 and elsewhere in the HM Treasury Paper) of the European-wide, and - indeed - international, nature of the financial stability work, and the fact that the FPC, PRA and CPMA will work closely and in co-ordination with their European and international partners.

What costs will the regulatory structure place on consumers?

8. Any increased costs of the new regulatory framework would ultimately be passed on to consumers in pricing, but the impact assessment in the HM Treasury Paper is optimistic. Costs are not only direct financial costs, but also, possibly more importantly, the increased costs - in terms of management and board time - of dealing with two or more regulators in terms of their demands for information, the potential introduction of new regulation, lack of understanding of particular business models that require explanation, and a whole host of other firm/regulator interactions.

9. In view of the fact that the supervisory enhancement programme led to a very significant increase in FSA staff numbers, especially on the supervisory side, and taking into account current economic conditions and strictures on both public sector and private sector budgets, the BSA believes that the combined overheads and budgets of the new regulators should be subject to a ceiling for the time being of, say, 90% of the current equivalent FSA measures.

10. In the summary (above) we make a series of practical suggestions to help control the cost of the new regulatory structure without jeopardising – but, rather, enhancing - its effectiveness.

11. If the new regulatory structure significantly inhibits diversity, innovation and competition, consumers could potentially pay a heavy price. As with many of the issues discussed within this overall agenda there are trade-offs to be made, and the precise costs and benefits of those trade-offs will become apparent only over time.

Power, roles and responsibilities

Do the Government's proposals appropriately assign roles and responsibilities between the different regulatory institutions?

12. Broadly, yes – this is their main strength. However, we consider it important to ensure that, beneath their own primary objectives, the FPC, PRA and CPMA are subject to the same (or as near as possible, the same) range of statutory factors to which they must have regard, including each other’s primary objectives, the importance of diversity in the financial system etc. Such a uniform position would be very much in the interests of consistency. As noted above, the new structure gives rise to potential conflict between the PRA and CPMA. Ultimately, financial stability is the main prize and that points to the PRA prevailing in any difference between the two regulators.

13. The one serious concern we have about the assignment of roles and responsibilities is the CPMA’s proposed role as "consumer champion". The fundamental point is that a rule-making and rule-enforcing body cannot have the impartiality essential for the task, while at the same time being a "champion" of one half of the interested parties. It is rather like a judge being told to apply the law in a case objectively, while at the same time being a "champion" for one of two litigants. Therefore, as noted above, we believe that the proposed primary objective for the CPMA should be extended to make explicit a requirement of fairness, impartiality and objectivity.

14. This is not to say that we don’t see a role for consumer champions. Many independent bodies fulfill this role, and it is an important role for the media. However, we question whether the consumer champion role is appropriate for a body that also has regulatory responsibilities. Moreover, directors of mutual firms are elected by consumers, and there is often a clear joint interest between building societies and consumers in meeting the same objectives. Indeed the BSA’s research clearly shows a much better record in meeting consumer needs on the part of mutuals than plcs in the UK.

Will there be unintended consequences of the Government's proposals for regulation on the prospects for non-bank financial institutions?

15. There is a risk that the new arrangements will favour the plc business model and have insufficient regard to alternative business models, such as financial mutuals, despite the fact that that financial mutuals tend to be subject to a more restrictive powers regime than plcs, thus making them inherently safer (but not, of course, entirely safe).

16. A mixed, diverse financial services sector is more likely to be financially stable than one that is dominated by a single type of business organisation. There is much evidence supporting the proposition; see for example, the speech by Andrew Haldane, Executive Director, Financial Stability, at the Bank of England Rethinking the Financial Network www.bankofengland.co.uk/publications/speeches/2009/speech386.pdf and the very recent research report by the Oxford Centre for Mutual and Employee-Owned Business, Kellog College, Oxford, which set out a detailed and extensive case for promoting corporate diversity in the financial services sector www.mutuo.co.uk/latest-releases/oxford-university-report-mutuals-deliver-economic-stability/.

17. Diversity also forms an important aspect of a competitive financial services industry (which the Coalition programme pledges to enhance still further). Accordingly, as noted above, the BSA welcomes the suggestion in paragraph 4.12 of the HM Treasury paper that the need to maintain diversity is suitable as a "have regard" for the CPMA.

18. The Government also needs to be alert to the risk that the overall package of the new regulatory structure and tighter prudential requirements leads to displacement or disintermediation - pushing business outside the regulated financial sector on any scale does not necessarily contribute to financial stability.

The Financial Policy Committee (FPC)

Should the FPC have a statutory remit? If so, what should that remit be?

19. In the light of the events of the last three years, the inescapable conclusion is that financial stability must be the fundamental objective of the FPC – this should be a statutory requirement, although the difficulties of defining stability are acknowledged. However, the HM Treasury Paper accepts in principle that the FPC should take into account other factors when pursuing its primary objective, such as the impact of certain macro-prudential tools on levels of lending and UK competitiveness, and the objectives of other regulatory authorities (paragraph 2.26). The BSA concurs with this view.

How should the success of the FPC, both in and out of crisis, be measured?

20. Clearly, the averting of future crises is the key measure. Out of crisis, a measured and proportionate approach, allowing the PRA and CPMA to carry out their activities on a day-to-day basis unhindered is important, but accompanied by proper oversight, appropriate management information, and a determination to take action when necessary. Also important is the delivery of a competitive diverse market, especially in the retail sector, where firms of different sizes and corporate forms can meet customers’ needs.

Given the international regulatory framework, what macro-prudential tools should be granted to the FPC?

21. The HM Treasury Paper sets out a range of tools (Box 2.C). We believe that the FPC's use of these tools should (i) be subject to consultation; and (ii) accompanied by an FSA-type compatibility statement - explaining with reasoning why the proposed use of the tool is the most appropriate way of meeting its stability objectives.

22. To the list of macro-prudential tools must be added the proposed funding mechanism for deposit protection envisaged in the European Commission’s proposals for an amended deposit guarantee schemes directive (DGSD). Building up a deposit protection pre-fund at the speed and scale envisaged by the Commission would have a major impact on profitability in building societies (and banks) over the next decade. This would compromise the UK authorities’ ability to deploy other macro-prudential tools. Accordingly, oversight of deposit protection and the FSCS must be the responsibility of the FPC/PRA and not the CPMA as suggested in the HM Treasury Paper.

23. It should be remembered that a great deal of work on relevant mechanisms (the special resolution regime, the FSA’s supervisory enhancement exercise, recent changes under the Financial Services Act 2010 etc) has already been carried out.

Has enough been done to mitigate the risk of conflict between the FPC and the Monetary Policy Committee (MPC)? Is the FPC appropriately structured in terms of:

· The balance between internal and external members?

· The size of the Committee?

24. The BSA acknowledges the examination given of the accountability of the FPC, beyond the statutory ‘have regard to’ provisions, set out in paragraphs 2.52 – 2.67 of the HM Treasury paper, and supports the measures proposed. It is very important to ensure that the accountability provisions work in practice.

25. As explained below, the BSA believes that the PRA and the CPMA should be subject, essentially, to the same statutory accountability provisions as the FSA. We recognise that the position of the FPC, as a body with high-level responsibility for financial stability is substantially different from the PRA and the CPMA, whose primary responsibilities are the regulation of individual businesses.

26. Nevertheless, in view of the fact that the FPC will be taking over an aspect of the work that was previously, to some extent, within the FSA’s remit, it would be sensible to consider each of the FSA’s accountability provisions and examine whether or not there is a case for applying them to the FPC. Such an examination would be in line with the IMF’s statement to the effect that a central bank, if given a stronger role in financial stability, should be subject to "robust mechanisms that ensure transparency and a high degree of accountability" (see paragraph 2.66 of the HM Treasury Paper).

27. We recognise that some of the FSA’s accountability provisions may be inappropriate for a broad financial stability regulator that might need to act quickly in the public interest. The BSA would not want to see any inappropriate restraints placed on the FPC.

28. The new arrangements are likely to focus attention on corporate governance at the Bank. Therefore, it would be appropriate to examine whether the FPC, like the FSA currently, should be required to have regard to good corporate governance in managing its affairs. Arguably, it should also be required to have regard to the views of the statutory panels. Another possibility is for the Treasury Committee to interview the Board members of the new regulators.

What characteristics, experience and qualities should the Government look for when appointing external members of the FPC?

29. A range of experience and expertise but, above all, independent-minded and measured individuals, capable of acting decisively when necessary.

The Prudential Regulation Authority (PRA)

Should the PRA be the lead authority over the Consumer Protection and Markets Authority (CPMA)?

30. The PRA should be the lead authority. The separation of roles is a positive move, but will not remove the potential tensions between financial stability and conduct of business. To take an entirely simplistic example, but one that illustrates the point, the imposition of a 1% mortgage rate and a 5% savings rate would be good for consumers, but not for financial stability. Externalising of tensions previously managed within a single regulator does not, by itself, abolish them.

Is it appropriate for the PRA (and CPMA) to adopt a judgements-based approach to financial regulation and supervision?

31. In principle, especially in times of impending crisis, it is better to rely on judgments than on systems. Having said that, regulated businesses are entitled to a reasonable degree of certainty and the judgements must be objective, impartial and based on facts. The ability of the PRA to deliver this will depend on the quality of staff it is able to recruit.

32. And the PRA's demands for information (eg to run stress tests) should be balanced against the costs to firms of providing this information, accepting that not every possibility can be continually evaluated. If mandatory intervention below certain capital thresholds, as mentioned in paragraph 6.17 of HM Treasury’s Paper, are introduced, this would limit the discretion available to the PRA, so any such regime would need to be carefully designed and articulated.

The Consumer Protection and Markets Authority (CPMA)

Do the reforms provide adequate protection for the consumer?

33. Yes – the establishment of the CPMA, focused on a single conduct of business role, could potentially provide a strong safeguard for consumers, as long as it does not conflict with the requirement for firms to operate in a prudentially sound manner. (We have noted above the need for the CPMA to be required to act fairly and impartially, which is in the interests of all concerned). However, the main protection for consumers is the choice that they are offered from a diverse range of businesses of different sizes and corporate forms.

To what extent will the regulatory and administrative burden increase for those firms who now have to deal with two regulators?

34. The impact assessment is optimistic in this respect, but still indicates that between 1,500 and 2,000 firms would be subject to regulation by both the PRA and the CPMA. There are clearly risks of spiralling regulatory burdens, especially for smaller firms. Appendix B of the Treasury paper explicitly recognises this. This is why the BSA has proposed a series of practical measures to reduce the risk – see the second point in the summary above.

Other issues

Should any of the proposed bodies be given responsibility for promoting competition in the banking and financial services sector?

35. It should be borne in mind that the principles of good regulation comprise a number of very important concepts, as set out in paragraph 4.10 of the Treasury Paper, including the relevant authority’s need to use its resources efficiently, the responsibilities of those who manage the affairs of authorised persons, proportionality of burdens and benefits, the UK’s competitive position, competition aspects etc. These should not be brushed lightly aside.

36. The BSA believes that, in exercising its functions, the PRA and CPMA should not place overriding importance on competition, competitiveness and innovation, but it should take these matters fully into account because they are integral to the businesses being regulated.

Should any of the proposed bodies have a role in promoting the City of London?

37. This is mainly a matter for the institutions that operate in the City, but in the interests of the UK economy, the issue is one to which the FPC should have regard. It should be remembered that much financial service activity takes place outside the City of London – for example, the services provided by building societies and other institutions throughout the rest of the UK.

22 September 2010