Financial Regulation
Written evidence submitted by Which?
Financial Regulation
1.
Whilst the major focus has understandably been on the failure of the tripartite system to deliver effective prudential regulation, there have also been serious flaws in the FSA’s approach to conduct of business regulation. This has led to a failure to deliver sustained improvements for consumers and a number of major problems surrounding issues like Payment Protection Insurance (PPI), endowment mortgages and bank charges. These failures cost consumers and the industry billions of pounds and damaged consumer confidence.
2.
Alongside to changes in structure we need fundamental changes to the approach taken in consumer protection, macro and micro prudential regulation. In summary, we believe that the measures we are proposing would lead to a more effective, efficient and accountable regulator
Consumer Protection and Markets Authority
3.
The objective for the CPMA should be to ensure a fair, transparent and competitive market in financial services, with particular focus on protecting consumers and ensuring market integrity. It should have a duty to promote effective competition and when discharging its functions should ‘have regard’ to factors including the price and value for money of financial products and services, the need to proactively disclose information and promoting public understanding of the financial system and financial inclusion. It should take a stronger approach to enforcement with higher financial penalties and action against individuals. It should also regulate products rather than simply examining the sales process. The Board should contain a number of individuals with experience and knowledge of consumer issues. Proper accountability can only come alongside improved transparency. Section 348 of FSMA should be removed and there should be a presumption in favour of disclosure of information.
Coordination between the CPMA, PRA and FPC
4.
Splitting responsibility between three different regulators does not remove the conflicts which can exist between different functions, but merely externalises them. We do not believe that the PRA should be given primacy over the CPMA. To permit the PRA to prevent the CPMA taking a firm-specific conduct decision sends a dangerous message to the industry that only firms which are small enough to fail without causing damage to financial stability will be forced to bear the full consequences of mistreating consumers.
Prudential Regulatory Authority
5.
The current supervisory approach to prudential regulation is not effective. The significant implicit subsidy received by the banking sector has eroded market discipline, distorted competition and encouraged banks to intertwine highly leveraged investment and wholesale banking activity with essential retail banking activities and the payments system. Responsibility for prudence must lie with the banking institution, its management, shareholders and debt providers and not be delegated to regulators. Stability is not created by trying to prevent failure, but by enabling firms to fail in a controlled way. The regulator must change its approach from attempting to prevent failure in all circumstances to ensuring that banks can fail, but without significant harm to their customers, vital banking services or the economy.
Macro-prudential regulation (Financial Policy Committee)
6.
We support the introduction of the Financial Policy Committee and note the implications of the use of macro-prudential tools such as changing Loan-To-Value limits and capital requirements on consumers. It is important that these issues are tackled prior to the start of the operation of the FPC.
Consumer Protection and Markets Authority
7.
Which? believes that structural changes will not, on their own, address the root causes of poor regulation. Major changes in approach are needed to ensure financial services consumers receive adequate protection from the new Consumer Protection and Markets Authority.
8.
The previous approach to regulation failed to deliver sustained improvements for consumers. It was an approach that was too reactive and failed to put in place the right incentives for firms, make competition work for consumers or ensure that there was a credible deterrent against poor practice. Instead of tackling the root causes of consumer detriment, the regulator sought to control the sales process. There was an emphasis on disclosure of information, rather than ensuring that consumers could understand and act on this information. This led to a number of major problems surrounding issues like Payment Protection Insurance (PPI), endowment mortgages and bank charges. These failures cost consumers and the industry billions of pounds and damaged consumer confidence.
9.
The ultimate purpose of regulation is to ensure that markets work in the interests of consumers. The CPMA should work to ensure that market forces can work more effectively in the financial services market so that companies which treat their customers fairly and offer good value for money products gain business at the expense of firms which do not. Similarly, it must be made clear to firms, their management and shareholders that a failure to treat customers fairly will have a significant detrimental effect on the firm’s reputation and bottom line.
10.
Over the past year we have seen a number of welcome changes to the FSA’s approach including a move from a purely reactive to a proactive approach and a greater willingness to tackle the root causes of consumer detriment. We are keen to ensure that this new approach is carried across to the new regime and that the CPMA is given the mandate, powers and tools to deliver improvements for consumers. In order to achieve this we believe the following issues must be addressed:
Mandate and objectives
11.
We believe that the objective for the CPMA should be to ensure a fair, transparent and competitive market in financial services, with particular focus on protecting consumers and ensuring market integrity. We have concerns about the unintended consequences that could result from the current proposed primary objective relating to "ensuring confidence" - for example, it could discourage the regulator from publicising bad practice or drawing attention to areas where markets are not working properly for consumers. As a result we believe the Government should reconsider the objective it has set out.
12.
Whatever its primary objective, we believe the CPMA should have a duty to promote effective competition. It should be given the necessary powers to regulate the sector to achieve this, including the ability to apply specific licence conditions to banks and exercise competition and consumer protection legislation. Its competition powers would be concurrent with the competition powers of the OFT and will enable the regulator to make market investigation references to the competition commission.
13.
In order for the CPMA to act as a strong consumer champion, we support the inclusion of a number of "have regards" including:
• The price and value for money of financial products and services: The loss of the Supreme Court case on unauthorised overdraft charges has exposed significant gaps in the ability of regulators to tackle unfair charges so we believe the CPMA should be given the authority and powers to these. We outlined a possible approach in our submission to the European Consumer Rights Directive and also raised this issue in our response to the Treasury Committee’s inquiry into Competition and Banking.
• The need to proactively disclose information which might influence a consumer’s decision to engage in a commercial relationship with a financial services company: there should be a presumption in favour of disclosure and information should only be withheld where its release would damage the interests of consumers.
• Promoting public understanding of the financial system: the regulator should ensure that consumers have, understand and can use the information they need to make decisions about financial products and services
• Promoting financial inclusion: This should recognise that in the same way as utility services, access to basic financial services are essential for consumers to properly participate in society.
14.
We support the removal of the need for the regulator to have regard to the international character of financial services and markets and the desirability of maintaining the competitive position of the UK and the desirability of facilitating innovation. We do not feel these are suitable objectives for a regulator tasked with consumer protection. The inclusion of "innovation" presupposes that innovation in financial services is always beneficial for consumers and markets. In actual fact, innovation of product design can frequently involve increasing complexity or products which benefit the industry not consumers. The need for regulators to have regard to "international competitiveness" creates a conflict of interest which tends to support the status quo and be insufficiently challenging to the industry.
Supervision and enforcement
15.
We welcome the intention that the CPMA will take a strong approach to enforcement to ensure credible deterrence. In order to achieve this we believe the following changes are necessary:
• Financial penalties will need to be significantly higher than those imposed by the FSA.
16.
Examples of fines in Payment Protection Insurance (PPI) cases have shown the level of fines issued were minute in comparison to the revenues firms generated from mis-selling – in the case of the January 2008 fine for HFC Bank Limited it represented less than 0.4% of sales revenue. Even after the FSA had decided to significantly increase the level of penalties it imposed for PPI mis-selling, the fine levied on Alliance and Leicester represented less than 3% of the revenue they gained from selling the product. It is unsurprising that the FSA’s regulatory activity in the market for Payment Protection Insurance has not had the desired outcome in ensuring that customers are treated fairly. We would suggest the CPMA looks at the example of other regulators who levy substantially higher fines for consumer abuses. Under the Competition Act 1998, the OFT has the power to levy a financial penalty of up to 10% of global turnover of the business involved. OFWAT and OFGEM have similar powers. British Airways was fined £121.5 million for collusion over fuel surcharges. Argos and Littlewoods were fined a total of £22 million for fixing the price of toys and games. OFWAT fined Severn Water £35.8 million for mis-reporting information and providing sub-standard service. Shareholders will only be incentivised to put pressure on senior management to ensure customers are treated fairly when financial penalties represent a significant proportion of the revenue gained from selling a product.
• Greater action should be taken against the senior individuals responsible.
17.
Senior management have to be clear that breaching regulations will result in serious consequences for themselves and for their firm’s reputation and bottom line. The CPMA should send a clear signal that it will take action against individuals, including greater use of orders prohibiting the individuals from working in the financial services industry.
Remuneration systems
18.
The CPMA should move from a purely reactive approach to one which seeks to tackle the root causes of consumer detriment. In our view, remuneration systems linked to sales targets create a conflict of interest between the consumer and the firm. They encourage banks to recommend courses of action which result in the sale of a product, rather than that which is most suitable for the customer. They also contribute to mis-selling. For example, advisers at Alliance and Leicester received six times as much bonus for selling a loan with PPI as they did for selling a loan without PPI. The CPMA should prohibit remuneration and commission systems for both frontline staff and senior management which encourage mis-selling.
Effective redress
19.
In the past ten years we have seen substantial detriment caused to consumers in a number of areas including mortgage endowments and Payment Protection Insurance. The impact of these problems on consumers has been compounded by the slow response of the industry and regulators. Excessively long timescales, poor complaints handling and inadequate redress have become all too common. The CPMA should adopt an effective redress system which improves the incentive for firms to treat customers fairly. Two approaches which should be adopted are:
• Past case reviews
20.
The CPMA must show greater willingness to utilise the s404 powers to require firms to actively review past sales of a particular financial product where detriment has occurred. This would be a similar process to a ‘product recall’.
• Collective redress
21.
The CPMA should introduce an improved method of collective redress which would allow a collective claim to be made on behalf of all those consumers who are adversely affected. This could have benefits for consumers in improving access to redress while reducing the administrative cost for firms and the regulator of dealing with individual cases. We believe that the Courts should have the power to ensure that claims could be done on an opt-out basis.
Conduct risk
22.
The CPMA should preserve the FSA’s Conduct risk division which is aimed at the identification of emerging risks before they crystallise and cause major consumer detriment. We also recommend that the CPMA should make greater use of market testing and mystery shopping.
23.
In addition, there should be a Committee introduced with members from the CPMA, OFT, FOS to share information about potential risks and the merits of dealing with the issue through a complaints-led approach or by regulatory action by the CPMA. This Committee would gather evidence from consumer and industry groups and set a timetable for investigation. This proposal would enhance the current ‘wider implications’ process. At the same time, we would favour a move towards a more formal process (along the lines of a supercomplaint process) which allows consumer bodies to raise potential issues with the CPMA and for the CPMA to publicly report on action taken.
Product regulation
24.
We believe that the CPMA should embrace the role that product regulation can play in addressing conflicts of interest, disciplining markets and aligning the interests of producers with consumers. In many markets, competition provides an effective force in shaping the products on offer and ensuring they meet consumers’ needs. However, effective competition relies on consumers being able to make informed choices, based on an ability to compare competing products with each other. This should cause firms which offer poor value and poor quality products to lose business at the expense of their competitors. However, this is frequently not the case in the financial services sector, where consumers’ ability to make informed choices are hindered by a combination of their lack of financial capability, product complexity, incomplete or unclear contracts, the length of time between the purchase of a product and discovering whether it has worked and a lack of transparency in the design and marketing of financial products.
25.
Product regulation could be used by the regulator to address three key issues:
• Ensure minimum standards for key products: There are certain products, such as current accounts and protection products, that consumers need access to. We believe the regulator should ensure that any such products meet minimum standards. We would draw a parallel with motor insurance where all products on sale must meet minimum legal requirements, and consumers then have the option to add on additional ‘bells and whistles’.
• Minimise the toxic aspects of products and in some cases prohibiting a particular type of product or specific product (for example single premium PPI): Product regulation can play a valuable role in limiting the harm that certain products can cause.
• Ensure the availability of ‘vanilla’ products: Experience has shown that the financial services industry alone will not develop simple, good value for money products which meets consumers’ needs. We believe the regulator should pursue the idea that providers and intermediaries should offer simple, straightforwardly priced ‘vanilla’ products alongside their additional product offerings.
Governance and accountability
26.
Further steps need to be taken to ensure that the regulator is subject to greater accountability than is currently the case with the FSA.
27.
We welcome the intention to make the CPMA subject to audit by the NAO. The regulator should also be accountable to the Parliamentary Ombudsman. We support the continuation of the Consumer Panel. The Consumer Panel must be properly funded and resourced. It is important to recognise the inherent imbalance in resources between those who lobby on behalf of the industry and those who lobby on behalf of consumers.
28.
In addition to increased oversight by the Treasury Committee, we believe it would be beneficial if the regulator made itself more available to scrutiny. This could take the form of a monthly question time where senior figures and board members were required to take questions from key stakeholders.
Board structure
29.
In the past, the fact that 10 of the 12 members of the FSA board had been currently or previously employed by the industry raised the risk that only the prevailing mindset of the industry gained credence in Board deliberations. There was a clear preference to codify existing industry practice instead of asking searching questions about whether markets were working efficiently and in the interests of customers.
30.
It is clear that alternative perspectives are needed and the Board of the CPMA needs to be more diverse, with an increase in consumer representation and Board members with experience and knowledge of consumer issues. It is important that all Board members are independent of the industry and should only be allowed to participate in decisions where they are free from conflicts of interest.
31.
We would also like to see greater transparency around the agendas, forward plan and minutes of board meetings to provide full information about when the Board is taking key decisions - though we acknowledge that financial stability considerations may occasionally limit the amount of information which can be disclosed in advance. It would also be useful to hold at least one public board meeting a year – where individual board members would take questions from stakeholders.
Regulatory transparency
32.
Proper accountability can only come alongside improved transparency. We believe that regulatory transparency could have a powerful effect towards incentivising firms to improve their practices. It also helps the industry as it ensures that, if scandals do arise, offenders are identified and the entire industry is not tarred with the same brush.
33.
The main roadblock to greater regulatory transparency is Section 348 of FSMA that prevents the FSA from disclosing information it receives in the discharge of its regulatory duties, except in certain defined circumstances. In addition to the problems involving its interpretation by the FSA, it also places substantial barriers to organisations making Freedom Of Information (FOI) requests to the regulator. It allows the regulator to reject FOI requests without being subject to a public interest test. Which? has submitted a number of FOI requests to the FSA asking for the names of mortgage lenders which had performed poorly in the FSA’s thematic work. We believed that consumers had a right to know which lenders were treating customers unfairly and that this information should also be shared with the Court judges hearing repossession requests from these lenders. The FSA rejected our request and offered a number of excuses including that it would harm the lenders brand and reputation, would undermine firm’s willingness to engage in a dialogue with the FSA and to provide the FSA with information and the restrictions imposed on it by Section 348 of FSMA. The FSA has also refused to disclose the instructions which it had given to firms which had been fined for mis-selling PPI, stating that as the instructions it gave to the firms would invariably involve information received from the firm, they would also not be able to disclose it due to Section 348 of FSMA. A culture of secrecy harms accountability and only benefits those firms breaking the rules.
34.
Section 348 should be removed and the text of the future legislation should reflect the minimum restrictions on disclosure required by EU directives. We believe this to only consist of a requirement for the FSA not to disclose confidential information it has received from other EU regulators.
35.
The actual practice of the CPMA would be influenced by a clear mandate to disclose information where it might help the CPMA achieve its objective of a fair, transparent and competitive market in financial services or where it might influence a consumer’s decision to engage in a commercial relationship with a financial services firm.
36.
In addition to the legislative changes, we would like to see further transparency in seven key areas.
• Thematic work: We believe the regulator should disclose the firm-specific results of the thematic work it undertakes. The current failure to name those firms performing poorly means that consumers are kept in the dark and firms are able to get away with not treating their customers fairly without suffering any practical penalty.
• Misleading financial promotions: We would like the regulator to take a similar approach to the Advertising Standards Authority (ASA) and introduce a Financial Promotions Register which shows where the regulator has received complaints and where a firm has been required to withdraw or amend a misleading financial promotion. This would provide a powerful incentive for firms to improve standards, would help draw the attention of consumers who may have responded to the misleading promotion, and could motivate more consumers and consumer groups to report adverts they find misleading.
• Price data: We would like the regulator to require firms to provide the relevant price data on their products, and use this data to publish comparison tables. This will make it easier for consumers to shop around to get the best rate and spot when they are getting a bad deal, and for organisations like Which? to warn them about products to avoid.
• Complaints data: The FSA has moved to publish complaint numbers for individual firms which receive more than 500 complaints every six months. However, we believe that the FSA should go further and publish all of the complaints statistics it receives from all firms online. As these are already collected by the regulator electronically, there should be no additional costs for individual firms.
• Own-Initiative-Variation-of-Permission: This would ensure that in a situation where the FSA has concerns about a firm and varies its permission to undertake specific activities. This could include restrictions such as not allowing the firm to accept new business, but can also include actions such as requiring firms to contact customers who have replied to a misleading financial promotion.
• Warning and enforcement notices: The FSA should publish details of the firms which it has referred to enforcement.
• Redress schemes: The FSA should publish the names of the firms which are subject to the scheme, list what activity the firms are undertaking, the text of all letters used in customer contact exercises, the criteria the firms are using to calculate redress, the response rates to any customer contact exercise and the amount of redress paid.
The Financial Ombudsman Service
37.
The existence of an effective consumer redress system is vital to ensuring confidence in the financial system and to facilitate the smooth running of the industry. Which? as an organisation has redress for consumers as a core principle. We support alternative dispute resolution systems as a cost-effective alternative for both consumers and firms. Which? believes that the FOS is effective at providing a method of dispute resolution which is fair to both consumers and firms. The FOS ensures a level playing field between firms and consumers and provides an effective alternative to the court system. It is important that the reforms to regulation do not downgrade the role of the FOS.
Interaction / Coordination between the CPMA, PRA and FPC
38.
It was clear from our discussions with a consumer group from a country that already operates this model that splitting responsibility between different regulators does not remove the conflicts which can exist between different functions, but merely externalises them. There should be coordination arrangements but we do not believe that the PRA should be given primacy over the CPMA. If a firm-specific conduct decision would impact financial stability by leading to a failure of a bank then the PRA has clearly not been undertaking its remit effectively. In the current environment we also do not believe that a decision to prevent the CPMA from taking a firm-specific decision which would lead to the failure of the firm would or should ultimately lead to the continued existence of that firm. If a firm has broken the regulations and/or common law and consumers have suffered financial detriment then it will not be possible for the PRA to extinguish the legal liability of the firm. To permit the PRA to overrule the CPMA also sends a dangerous message to the industry that only firms which are small enough to fail without causing damage to financial stability will be forced to bear the full consequences of mistreating consumers. We believe that the Government should publish some scenarios showing the circumstances which it believes might lead to the PRA overruling the CPMA in a firm-specific conduct decision.
39.
There will also need to be a coordinated approach between the CPMA and PRA for breaking up any banks which pose a systemic risk or harm competition. Under the new regime there would be two possible reasons for restructuring or breaking up a bank. For example, the competition authorities may have concerns about the dominant market share of one individual bank in the mortgage market. The prudential regulator could have similar concerns regarding the dominant position of that bank on the basis that it would make it impossible for the bank to fail without causing significant damage to the economy.
40.
The CPMA will also need to provide input to the PRA on the preparation of ‘living wills’ to ensure that these cover how customers will be treated and provide sufficient protection for customers’ interests.
41.
The PRA and CPMA will need to work closely together in making their respective decisions about the granting, amending or withdrawing permissions for particular activities. For example, permission to be active in the mortgage market could include activities which would be of interest to the PRA (mortgage lending) and the CPMA (advising and arranging mortgage contracts).
42.
The supply chain for financial services is complex and it is possible for a firm designing a product to have no contact with consumers (by distributing the product through third parties). We would like clarification about where the regulation of the product design phase would be located if the firm was not regulated by the CPMA.
Prudential Regulatory Authority
Problems with the current approach to prudential regulation
43.
Which? is concerned with the current approach to regulation of banks and the legacy of the Government’s intervention during the financial crises. These have significant effects on the prospects for competition in retail (and likely SME) banking by creating:
• Distortionary subsidies, direct through state aid bailouts and indirect by reducing funding costs, to the largest market incumbents thereby strengthening their market power; and
• No effective regime to enable market exit by failing banks (whether due to poor management or dissatisfied customers) while preserving financial stability of the economy as a whole.
44.
These concerns relate to the public policy for regulation of banks and the role of UKFI in managing taxpayers’ stake in those banks that relied upon state aid to avoid failure. Further reform should also be taken in the overall approach to regulating banks: too often regulators are held accountable for banks’ decisions that create instability or put consumers at risk and those same banks remain in business regardless.
Regulation – implicit subsidy
45.
Which? established a Commission into the Future of Banking early in 2010, and received evidence from key players amongst banks, regulators and government. Evidence to the Commission made it clear that the banking industry enjoys a significant public subsidy, in the form of tax payers’ funds used to protect failing banks from insolvency. Lord Myners noted that "the banking industry, because it’s been underwritten implicitly against failure, without paying a premium, has enjoyed a huge subsidy". This was evident in the approach to bank failure during the crises but also marked a long-standing trend, when dealing with risks to financial stability, of preserving the status-quo by state aid or by merger.
46.
This subsidy arguably distorts decision making by banks, fostering riskier behaviour than would otherwise be acceptable, while enabling those banks to raise funds more cheaply. For those banks requiring taxpayer support, it has been necessary to support the whole bank, not just the assets and liabilities linked to essential banking activities such as the payment transmission system or securing customers’ deposits. Mervyn King noted to the Future of Banking Commission: "Ultimately the heart of the problem does come down in my view to the inherent riskiness of the structure of banking that we’ve got, and the difficulty of making credible the threat not to bail out the system, which is what is underpinning the implicit subsidy and creating cheap funding for large banks taking risky decisions."
47.
It has been argued that the value of this subsidy, which distorts the cost of capital for banks, has increased over the course of the financial crisis as the implicit subsidy became explicit support, and is greater for larger than smaller banks. For example, Andy Haldane of the Bank of England estimates that the subsidy for the biggest 5 banks in the UK amounted to £50 billion for the period 2007-09, representing about 90 per cent of the total implicit subsidy available to the banking industry. In its submission to the Future of Banking Commission Virgin Money estimated private equity investors demanded a 10 – 13 per cent higher cost of capital from new entrants than from the largest incumbents: effectively double the cost facing the largest banks.
48.
This subsidy results in a significant moral hazard. It fundamentally erodes the ability of small or new entrant banks to become serious challengers to the large, established incumbents. As a result market discipline, the key mechanism of competitive markets, is made ineffectual: good banks are unable to drive out the bad, while big banks remain big. By encouraging high and excessive leverage, the implicit subsidy actually increases the likelihood of taxpayers being forced to step in and support the banking sector. It also encourages banks to intertwine highly leveraged investment and wholesale banking activities with essential retail banking activities and the payments system.
Is it appropriate for the PRA to adopt a ‘judgement-based’ approach to financial regulation and supervision?
49.
Whilst we accept the criticism of the previous regulatory approach to prudential regulation, expecting a move to a more judgement-focused approach with regulators exercising judgements about the safety and soundness of firms through greater supervision to lead to greater outcomes poses two particular problems. Firstly, because the increasing trend to put reliance on the regulator’s supervision of compliance with international capital adequacy standards, such as those set by the Basel Committee on Banking Supervision, has created perverse incentives for banks to game the rules. Secondly, judgement-based supervisory regulation can all too easily turn into ‘shadow management’ and there is a limit to how effective this approach can be to regulating individual firms. Supervisory regulators will always be outnumbered by market participants who retain an informational advantage.
50.
In his evidence to the Future of Banking Commission, Mervyn King cited the example of Citibank, which still faced near collapse during the crisis despite high calibre management and very close supervision by ‘dozens’ of regulators embedded within the firm. He note that "I cannot believe that any regulator in the world could honestly pretend that they would do better than what happened [at Citibank], and I think we have to recognise that sometimes things happen which are almost impossible to anticipate, hard to calibrate in advance in terms of how much capital you need to put aside, or how much cash you need to bank, in order to be sure that you won’t get into trouble … Having a system that’s robust with respect to that seems to me of fundamental importance, and as I understand it, that is exactly what regulators in other industries supplying utilities would encourage us to do"
51.
Which? agrees that the lessons of other regulated industries have not been applied to financial services. In other industries, regulators strive to establish the pre-conditions for effective competition. It has always been recognised that for effective competition to be possible, the regulator has to ensure there are specific arrangements in place which allow firms to fail while ensuring the continuity of essential services. For example, in the Water Industry when Enron acquired Wessex Water, OFWAT imposed conditions including requiring the Board to act as if it was an independent company and prohibited cross-default operations. Their primary objective was not to protect Enron’s shareholders, but to ensure that customers would continue to receive an essential service and that the creditors of Enron corporation should have no recourse to the assets of the Water company. The result was that when a combination of fraud and incompetence caused Enron to collapse, the ring-fencing provisions ensured that Wessex Water was able to continue to function and essential services were maintained.
52.
The prudential regulator must change its approach from attempting to prevent failure to ensuring banks can fail, but without significant harm to vital banking services or the economy. Stability is not created by preventing failure, but by enabling firms to fail in a controlled way. The PRA would be the guardian of the ‘living wills’ which banks would be required to produce.
53.
Ensuring that banks face a realistic prospect of failure would help improve the accuracy of the pricing of equity and debt to individual banks and help ensure that these more accurately reflect the risks of a specific bank. Responsibility for prudence must lie with the banking institution, its management and debt providers and not be delegated to regulators.
54.
The PRA would take pre-emptive steps to:
1) Protect ordinary depositors and retail customers
2) Ensure the continuity of all essential retail banking services
3) In the case of any institution that is too big or otherwise too significant to fail, intervene to restructure that institution such that its failure would no longer present a systemic risk
55.
The PRA should have a specific duty to promote competition. This would help support its focus on not preserving the status quo or existing institutions, but creating a market with the realistic prospect of failure. It would also ensure that the PRA does not impose excessive barriers on new entrants, by making them carry higher levels of capital or liquidity than existing banks. It should also have an objective to limit and remove the extent of the implicit subsidy received by the banking sector, which distorts competition and disadvantages new entrants.
56.
The PRA should need to "have regard" to the objectives of the CPMA. It will need to work with the CPMA to ensure that ‘living wills’ and the arrangements for the provision of essential banking services offers sufficient protection for customers’ interests. The PRA should take responsibility for monitoring and setting down standards for remuneration practices which could work against its objectives for the stable and prudent operation of the firms it regulates.
57.
We support the proposal that the PRA will not need to "have regard" to the competitiveness of the UK as a location or the need to promote innovation. This is for similar reasons to those explained in paragraph 14.
Governance and accountability of the PRA
58.
The consumer panel established as part of the new regulatory function should also monitor, advise and challenge the PRA through its policy development to ensure that it takes into account the interests of consumers. The PRAs rule-making function should be subject to statutory processes which include consultation with the consumer panel. It is important that the PRA is not subject to excessive restrictions on its disclosure of information. Indeed, an approach which involves the active disclosure of supervisory information to the markets would be preferable. We welcome the fact that the PRA will be subject to audit by the National Audit Office.
Macro-prudential regulation
59.
We support the introduction of the FPC to address systemic risk and to implement macro-prudential regulation. Consumers and small businesses have been damaged by a move from ‘feast to famine’ in the availability of credit. The purpose of systemic risk regulation should be to oversee liquidity and capital standards at the macro level. It should be concerned with the inter-dependence of banks and their exposure to common economy wide shocks that may affect key sectors such as commercial and domestic property. Its role should be to act counter-cyclically, to smooth the credit cycle and to ‘take the punch bowl away’ when credit growth led asset price bubbles grow unsustainably and threaten to lead to instability. This is not an easy task and the framework should ensure that the FPC has the credibility and expertise to challenge the prevailing consensus and to take appropriate action. We also believe that it would be advantageous for some of the external members of the FPC to have expertise and knowledge of consumer issues.
60.
However, we express a note of scepticism about the potential effectiveness of macro-prudential regulation to prevent a financial crisis, not least because of the risks of regulators becoming victims of ‘flawed intellectual models’ and the incentive for banks to find their way round any targets and rules. Increasing the role of macro-prudential regulation also raises questions about the fundamental purpose of banks and bankers. The raison d’etre of a banker should be to restrict credit to sectors of the economy (such as commercial property) which become over-valued.
61.
Which? do not have the expertise to evaluate the effectiveness of the different macro-prudential tools proposed, so we have concentrated on their potential impact on consumers. This could fall into two different categories:
62.
Loan-to-Value limits for residential mortgages: When these are changed they will inevitably lead to a number of consumers being stranded with their existing mortgage provider. For example, if a consumer has just taken out a 95% LTV mortgage and the FPC decides to limit the maximum LTV to 90% then that consumer will be unable to move to a different lender (and unless their mortgage is fully portable, to a different house). It is also likely that a reduction in the maximum LTV would lead to house price falls which would further exacerbate the position of that consumer. Unless mortgage contracts are tightly defined, banks will be able to exploit these captive customers by increasing their margins.
63.
Other capital requirement changes: It is likely that banks will use any changes to capital requirements or risk weights to alter the price paid by existing customers. For example, many terms and conditions will allow banks to vary the contract in response to decisions by "regulators". How any changes to price will be applied and the discretion which firms may use to apply these changes are likely to be relatively opaque to consumers (unlike clear contractual terms which could exist for changes in interest rates to follow a clearly defined and transparent reference rate such as a product where the interest rate tracks the Bank of England base rate). We have concerns that firms may seek to apply these changes unfairly or to exercise unfair contract terms. There will also be conflicting messages for consumers if the MPC is lowering the base rate at the same time as the FPC is increasing capital requirements for particular types of consumer lending. The exact terms of contracts are likely to be issues for the CPMA, but how firms may exercise their discretion may also have systemic impacts if, for example, all banks are confident that they will be able to react to any changes in capital requirements by immediately passing on the costs to existing customers by increasing rates.
Annex 1
Shortcomings of Competition Regulation under the Financial Services and Markets Act 2000
Competition regulation under FSMA is, at best, wholly inadequate and, at worst, detrimental to the competitive landscape in the financial sector. The ambit of the FSA is currently centred on the maintenance of market confidence, raising public awareness, the protection of consumers and the reduction of financial crime. While the FSA also has, among its primary duties set out in FSMA, the requirement to have regard to ‘the desirability of facilitating competition between those who are subject to any form of regulation by the Authority’, FSMA does not give the FSA concurrent competition powers with the OFT, which would allow it to either (a) directly apply competition law or (b) refer markets to the Competition Commission, as is the case for the regulators of other industries. It is clear that the FSA’s approach is to avoid putting up further barriers against competition, rather than proactively seeking to improve the degree of effective competition in the industry. Indeed in some sectors of the market such as with-profits funds, the FSA actually applies different rules to existing firms, compared to any recent or potential new entrants. The inadequate focus on appreciating the benefits which competition can bring can also lead to codifying existing industry practice instead of driving improvements for consumers. For example, instead of improving the ability of customers to switch cash ISAs, the FSA simply required that the banks provide a "prompt and efficient service" and referenced existing industry guidance.
Indeed, in its composition, FSMA gives the impression to market participants in the financial sector that they have a degree of immunity from UK competition law since agreements or conduct by a dominant firm, which would usually breach competition rules, are not subject to enforcement if ‘encouraged by any of the Authority’s regulating provisions’. This provision of FSMA effectively puts the maintenance of effective competitive markets in the financial sector subordinate to FSA regulation, albeit that European competition law can be applied regardless of this exclusion. Competition law considerations were further disregarded when, in the course of the financial crises, the public interest test for merger regulations was widened to include ‘financial stability’, allowing the Secretary of State to rule in the case of bank mergers, rather than the OFT or the Competition Commission.
The OFT has some specific responsibilities under FSMA 2000, necessary to compensate for the lack of competition objectives in the FSA’s mandate. Section 160 of FSMA requires the OFT to keep the regulating provisions and practices of the FSA under review, and report any significantly adverse effects to the Competition Commission: a process known as ‘competition scrutiny’. There have been no occasions under current legislation where the OFT has exercised this power. So, while the OFT may be suited to ‘repairing’ or conducting investigations into previous competitive markets, it is not up to the proactive task of regulating vigilantly to make markets in the financial sector more competitive.
This special treatment of the financial services industry sends a clear message to both the regulator and industry that the ‘normal’ rules of competition do not apply.
Annex 2
Payment Protection Insurance mis-selling
The mis-selling of Payment Protection Insurance (PPI) is an example of how a poorly functioning market, and a failure to intervene at an early stage to fix it, can disadvantage customers. PPI is designed to cover your debt repayments if you can’t work – for example, you become ill or have an accident, or you are made redundant. It is sold alongside loans, mortgages, credit cards and store cards. In the past decade, PPI has been subject to widespread mis-selling, and this has resulted in millions of consumers holding expensive insurance they would never be able to claim on.
PPI offers a clear example of a poorly functioning competitive market, as the sale of this product involved: (a) lack of adequate disclosure to customers about the product they were buying, and the resulting asymmetry of information between provider and customer; (b) inappropriate default settings, where it was left to the customer to opt out of buying the product when purchasing another financial product; (c) the existence of inappropriate commission structures, which focused the rewards for salespeople on selling PPI, rather than serving the customer well; and (d) accounting practices which allowed firms to book an upfront profit from selling single premium PPI policies.
The resolution of the problems in PPI has taken a long time. Which? first raised concerns about the mis-selling of PPI in 2002. An initial ‘supercomplaint’ by Citizens Advice was made in September 2005 to the Office of Fair Trading (OFT). The OFT followed up this complaint with a market study, launched in April 2006, which subsequently led to a market investigation reference, in February 2007, to the Competition Commission (CC). In 2009, the CC ruled it would be banning the sale of PPI alongside credit products, stipulating that lenders and credit card providers would have to wait at least seven days before approaching a customer about the sale of PPI. Following an unsuccessful appeal by the banking industry, the CC provisionally confirmed this ruling in May 2010, and published its final remedies in July 2010, almost five years after the issue was first raised by Citizens Advice.
In 2005, the FSA conducted a series of mystery shopping and supervision exercises and in September 2005 called on firms to take "urgent action" to ensure that their selling practices for PPI were compliant with regulatory requirements. However, firms did not respond to the FSA’s regulatory action and continued to mis-sell PPI. The FSA responded by conducting further rounds of mystery shopping and eventually conducting enforcement action and levying fines. However, these fines were such a low proportion of the revenue gained by banks from selling PPI they failed to have the desired effect. Despite, widespread mis-selling, no senior management in financial services organisations had enforcement action taken against them. The only senior management individual to have enforcement action taken against them for mis-selling unsecured loan PPI was the chief executive of a furniture retailer (Land of Leather). Eventually, at the start of 2009, the FSA eventually secured "agreement" from the industry to stop selling single premium PPI on personal loans. The problems for consumers have been compounded by the failure of firms to deal with complaints fairly. Consumers have faced unreasonable delays and the Financial Ombudsman is upholding over 90% of complaints received about some firms. This indicates that many firms are dismissing valid complaints and hoping that consumers do not go to the Ombudsman. The FSA is currently consulting on an approach to require firms to review previously rejected complaints. The FSA announced in September 2009 that several banking groups had agreed to undertake a voluntary review. However, almost a year later, Lloyds TSB disclosed that it had yet to start its review of past sales.
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