The Future Framework for Regulation of Financial Services Contents

---

1The Treasury’s proposed future framework

Existing UK financial services legal framework

8.The Financial Services and Markets Act 2000 (FSMA) sets out the objectives of the Financial Conduct Authority (FCA). It sets the FCA a single strategic objective to ensure that the relevant markets function well, and in addition three operational objectives:

• to secure an appropriate degree of protection for consumers;
• to protect and enhance the integrity of the UK financial system; and
• to promote effective competition in the interests of consumers.

Below each of these objectives is a set of issues to which the FCA must have regard. These number eighteen in total.

9.The Act similarly sets out the objectives of the Prudential Regulatory Authority (PRA). It sets the PRA a single general objective of promoting the safety and soundness of the firms it regulates, through ensuring that firms’ business is carried on in a way which avoids any adverse effect on the stability of the UK financial system, and minimising the risk they pose to financial stability.1

10.The PRA has an additional insurance objective of contributing to the securing of an appropriate degree of protection for those who are or who may become policyholders. The PRA has a secondary competition objective which requires it, when discharging its general functions in a way that advances its objectives, so far as is reasonably possible, to act in a way which facilitates effective competition in the markets for services provided by the firms it regulates.2

11.Section 3B of the FSMA states that both the FCA and the PRA must apply the following regulatory principles:

• the need to use the resources in the most efficient and economic way;
• a burden or restriction which is imposed should be proportionate to the benefits;
• the desirability of sustainable growth in the medium or long term;
• consumers should take responsibility for their decisions;
• the responsibilities of the senior management of persons subject to requirements imposed by or under this Act, including those affecting consumers, in relation to compliance with those requirements;
• a recognition of the differences in the nature of, and objectives of, businesses carried on;
• the desirability of publishing information relating to persons on whom requirements are imposed by or under this Act, or requiring such persons to publish information, as a means of contributing to the advancement by each regulator of its objectives;
• transparency.

12.Section 1JA of FSMA (for the FCA) and Section 30B of the Bank of England Act 1998 (for the PRA) allow the Treasury to make recommendations to the regulators about aspects of the Government’s economic policy, to which the regulators should have regard. In the remit letters sent most recently by the Chancellor to the regulators, the aspects of the Government’s economic policy to which they must have regard are:

• Competition
• Growth (including levelling up)
• Competitiveness
• Innovation
• Trade
• Better outcomes for consumers
• Climate Change3

Context of EU legal framework

13.During the years of the UK’s membership of the EU, an increasing amount of financial services regulation was set at the EU level, in EU directives, often referred to as “files”. The Treasury’s Future Regulatory Framework Review consultation states that:

The development of a single market in financial services, as well as interventions to address regulatory failures of the financial crisis, have resulted in EU legislation covering many key areas of regulation. This includes the prudential regulation of banking, insurance and investment firms as well as wide-ranging regulation covering financial markets activity and infrastructure.4

14.There are four tiers of EU regulation:

• Level 1 rules are the EU’s overarching legal frameworks for specific financial sectors, such as Solvency II or MiFID II.5 They are analogous to Acts of Parliament. These laws are based on an initial proposal by the European Commission (essentially a Bill), which the European Parliament and Council of Ministers (where EU Member State governments are represented) then scrutinise separately. Only when the European Parliament and Council have agreed on a legal text can it be formally adopted and take effect as EU law.
• Level 2 rules are legally binding technical implementing and regulatory measures that flesh out Level 1 laws, similar to Statutory Instruments in the UK.
• Level 3 rules are non-binding policy documents relating to Level 1 and Level 2 rules produced by the three European supervisory authorities: the European Securities and Markets Authority (ESMA), the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA), in their areas of responsibility. They include, for example, guidance to national financial regulators in EU Member States on how to interpret specific elements of the rulebook.
• Level 4 relates to supervision of the national implementation of Levels 1, 2 and 3 of the EU financial services rulebook carried out by the Commission and European supervisory authorities.

15.In order to avoid any regulatory gaps when the UK left the EU, the UK moved all of the EU-derived financial services rules into UK statute, a process known as “on-shoring”. The Treasury’s consultation paper (written prior to the end of the transition period) explained it as follows:

The European Union (Withdrawal) Act 2018 saves all EU-derived domestic legislation (for example, legislation implementing EU Directives) and transfers directly applicable EU law (for example, Regulations) onto the UK statute book.6

The proposal

16.Having all of the EU-originating financial services regulations in statute following withdrawal from the EU was not the Treasury’s desired long-term solution, due to the inflexibility and fragmentation of rules that this created, as well as the inability of regulators to change their rules as they saw fit. If the rules were to remain in statute it would require in some cases primary legislation to effect change, or in others Treasury Ministers to make change through secondary legislation.7 The Treasury is therefore proposing to move these rules out of statute and into the regulators’ rule books and to give the responsibility for setting future rules in these areas to the regulators. The proposal states that:

The default approach would be for any retained EU law provision that is in scope of the regulators’ FSMA rule-making powers to be taken off the statute book to become the responsibility of the appropriate regulator.8

Activity-based regulation

17.The Treasury’s consultation also proposes that through primary legislation, Parliament would set “activity-specific” policy framework legislation for the regulators. This legislation would set the purpose of a regulatory regime, the core elements of the regulatory approach to that regime, the issues to which the regulators must have regard to within the regime, and how the regulators would explain how they are meeting the requirements set for them by the legislation.9 It would be for the regulators to decide for themselves the rules needed to fulfil the objectives set for them under this legislation.

18.The proposal for regulation to take place under activity-specific frameworks is a largely new one for UK financial services. Since FSMA was introduced, the UK approach to financial services regulation has been to set high-level broad statutory objectives and regulatory principles for the FCA and the PRA in primary legislation, supplemented by an ability for the Treasury to make recommendations to the regulators about aspects of the Government’s economic policy to which the regulators should have regard. Prior to the Financial Services Act 2021 (described in more detail later), and with the exception of one specific insurance objective for the PRA of “contributing to the securing of an appropriate degree of protection for those who are or may become policyholders”,10 the regulators are largely not instructed in statute as to how they should regulate specific financial services sectors.

19.The Treasury consultation uses insurance as an example for how activity-specific principles would work:

The legislation would include an explanation of specific policy priorities relevant to insurance prudential regulation, set out in regulatory principles, that the regulator should take into consideration when developing policy and designing regulatory requirements for that particular activity.11

20.While activity-based regulatory principles are proposed in the Treasury’s consultation, the Treasury is already using them as a policy and legislative measure. This was confirmed when we asked John Glen MP, the Economic Secretary to the Treasury, for examples of where activity-based regulation might be helpful. The Economic Secretary’s response was that the Treasury had already used it.12 Gwyneth Nurse, Director of Financial Services, HM Treasury, explained the issues in more detail:

The particular areas of focus that we were considering really came through the Financial Services Act 2021 in the sense of Basel and the investment firms prudential review, where you saw that the Government added the specific “have regard” there, particularly to “as a place for internationally active investment”. That allowed us to build on the overarching principles and objectives, and to bring a spotlight to the areas in those files that Parliament wanted the regulators to consider. If you look at that approach and extrapolate it outwards, that is the kind of thing that we are driving at in the future regulatory framework.13

Moving on-shored rules into statute

21.Transferring the regulations out of statute will be a significant enterprise. The FCA is responsible for 40 EU files14 that have been on-shored, and the Bank of England is responsible for two. Vicky Saporta, Executive Director of Prudential Policy Directorate at the Bank of England, told us that the on-shoring process for the Bank alone involved “lawyers and specialist teams […] working through 10,000 pages of rules and another 6,000 of technical standards.”15 The Economic Secretary told the Committee that it was “realistic” that it would take several years for the on-shored rules to be moved into the regulators’ rule books.16

22.When we asked the FCA in what order this work should be done, Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, said:

[it] could be done in one lump or in chunks, whichever best serves the objective of getting this rule set into a place where it can be kept up to date. […] If Parliament wanted to scrutinise each of the different files and we tried to do them all in one block, we might not get to number 40 until quite a long way down the track, and it would have been better to get numbers 1, 2, 3, 4 and 5, which might be the most important ones, done first.17

23.When we asked Mr Schooling Latter whether the FCA would want to make changes to rules as they were moved into its rulebook, he said that it would depend on the rule:

The broad picture would be one of continuity. On the other hand, if we knew there was a case to change something, why not take the opportunity to do that while the exercise was being conducted?18

24.While there is agreement on the need to move the on-shored rules out of statute and into the regulators’ rulebooks, we did receive written evidence from Aviva stating that it did not believe that all financial services regulation should be moved out of statute entirely. It told us that:

The legislation that provides direction to regulators needs to be specific enough to: […] create enough specificity to empower genuine legal review. […] Sufficient reference in legislation allows the purpose and intent of these tools to be set by policymakers but still leaves significant latitude to the PRA in the design and operation of the rules, albeit within the clear parameters set in legislation.19

UK-derived rules

25.Not all financial services rules that sit within UK statute are there as a result of the UK’s membership of the EU. The Treasury consultation gives the example of ring-fencing rules and states that the location of rules within legislation has been a problem for the regulators:

In areas of financial services regulation not covered by EU legislation, regulators have usually had more policy discretion as originally intended by the FSMA model. But there have been exceptions to this. Domestic regulation to ring-fence banks is an example of setting requirements on firms through the use of more detailed legislation, in this instance constraining the PRA somewhat in designing and calibrating the requirements.20

26.We asked the Bank of England whether they felt “constrained”, as the Treasury described it, by the ring-fencing rules being in statute. Vicky Saporta, Executive Director of the Prudential Policy Directorate at the Bank, told us that “the way that the ring-fencing regime was set up was fine. We have not felt particularly constrained. […] It is very early days. We might see constraints that we have not yet seen”.21 She also said that the Bank was not at all opposed to how ring-fencing was legislated for,22 and the Bank was not pushing for it to be taken out of statute.23

27.We agree with the Treasury that the body of EU financial services rules that was on-shored during the process of leaving the EU should be moved into the regulators’ rule books. Keeping rules in statute could require Parliament to amend or pass new legislation every time that the regulators wish to make changes to them. This would be resource-intensive and impractical. The regulators have a key role to play in designing and developing the rules with appropriate Parliamentary oversight. We acknowledge that the process of moving rules out of statute will be time-consuming for the regulators and will be a heavy demand on their resources. It is important that the required resources are provided to ensure this process takes place efficiently.

28.The Treasury consultation alluded to certain UK-derived rules that are set out in UK statute, and it suggested that regulators might be constrained as a result. But we found that the regulators did not appear to feel constrained by the existence of any domestic rules being set out in statute. We therefore conclude that while periodic review of domestically-derived rules to see whether they would fit better in rule books rather than in statute may be necessary, they do not need to be included in the exercise that moves the EU on-shored rules out of statute and into the regulators’ rule books.

Ministerial oversight of regulator proposals

Is there a need for change?

29.Another element of the Treasury’s proposal is that Ministers would be given sight of regulatory proposals at an earlier stage in the policy formulation process. The consultation states that:

The Government proposes a general arrangement whereby the regulators consult HM Treasury more systematically on proposed rule changes at an early stage in the policy-making process and before proposals are published for public consultation.24

30.The Bank of England and the Financial Conduct Authority are operationally independent of the Government. The Treasury’s own consultation sets this out clearly:

The regulators operate independently from government and Parliament. As long as the regulators are acting within their FSMA statutory powers, and in accordance with other relevant financial services legislation, judgements on policy, rule-making and supervision are for the regulators to make.25

31.The consultation states that the reason to change the process is to give Ministers more time to consider policies. The proposals would:

Give the Treasury sufficient time to consider any broader public policy implications that regulator proposals may have and to allow the opportunity to feedback views to the regulators if necessary. It is important to stress that this policy coordination arrangement would only allow the Treasury to feed in views as regulator policy is being developed. It would not give Ministers a veto over the regulators’ rule-making functions or act as a constraint around the regulators’ policy discretion when designing rules.26

32.We asked the Economic Secretary whether he wanted to change the law so that Ministers can change policy proposals, and he said “no”,27 and he also said that “I do not have any aspirations as a Minister to grab power for myself.”28 He explained the proposal by saying “what is sometimes helpful is for Ministers to be able to take account of the broader public policy landscape.”29 The Treasury consultation states that formalising the Treasury’s sight of policy proposals before they reach the public consultation stage “could be achieved by requirements in legislation, arrangements set out in a Memorandum of Understanding (MOU) or a combination of the two.” Gwyneth Nurse told the Committee that “The consultation leaves open the possibility of making a legal change, just by way of systematising what might happen in terms of a conversation”.30

Regulator views

33.When we asked the regulators at what stage ministers were informed about policy proposals, Edwin Schooling Latter, Director of Markets and Wholesale Policy at the FCA, told us that the FCA were “already more or less in a routine of discussing with our Treasury counterparts during the policy formulation process. […] It is better if the Treasury has the chance to comment on the ideas that we are working on […] rather than to find that our counterparts in the Treasury are surprised on the day of public announcements.” The Economic Secretary told us that “Virtually every day, I have some sort of interaction with one of the deputy governors or somebody from the FCA, and they are embedded into a lot of our decision-making”.31

34.Vicky Saporta agreed, saying that the Bank staff “co-ordinate with and speak to the Treasury regularly at the official level, not least because we need to co-ordinate certain policies, so that we do not come out with something that clashes with what Treasury wants to do, without having considered the appropriate timing for it or the issues involved”.32

35.When asked, the FCA and the Bank also told us that they had never had policies stopped by the Treasury. Vicky Saporta did say, however, that there had been times where the Treasury had instructed them in the timings of making changes, in the context of negotiating the new arrangements with the EU, but she did qualify this by saying “delay is different to stopping”.33

36.We understand the need for Treasury Ministers to be well informed of the regulators’ policy intentions as a matter of routine. However, we have not been provided with compelling evidence to justify changing the law to allow Ministers the absolute right to see financial services regulators’ policy proposals before they are published for consultation as opposed to the current arrangements whereby significant interaction between Ministers and regulators happens informally as a matter of routine. By doing so, the perception of regulatory independence from government could be damaged. The independence of regulators to be free from political interference is one of the key aspects of UK financial services regulation, and it is, arguably, one of the reasons why the UK is a world-leading financial centre. Regulators must continue to be free to choose what they share with the Treasury in this respect.

37.The Treasury has in the past been able to delay policies in the interests of the wider negotiations that took place during the UK’s departure from the EU. This suggests that there is already sufficient and appropriate Treasury oversight of the regulators’ policy proposals without needing to put such a power in law.

38.If the Treasury does wish to give itself the formal power to see policy proposals before they are made public, comments or suggested changes to them using this power should be published alongside the public consultation.

Activity-Based Approach views

Is there a need for change?

39.The Treasury itself still believes that the overall FSMA regulatory model is fit for purpose. In the Executive Summary of its Financial Services Future Regulatory Framework Consultation, it writes:

The government believes that this model, which delegates the setting of regulatory standards to expert, independent regulators that work within an overall policy framework set by government and Parliament, continues to be the most effective way of delivering a stable, fair and prosperous financial services sector. […] It allows regulators to flex and update those standards efficiently in order to respond quickly to changing market conditions and emerging risks.34

40.But the Treasury’s consultation put forward a case for new regulatory principles, saying that these were needed because although the original FSMA “set high-level general objectives and principles, it did not provide for government and Parliament to set the policy approach for specific areas of financial services regulation”.35

41.However, when we asked the Economic Secretary about whether the Treasury was moving towards a more activities-based approach he said “Not really, no”, and went on to explain that “We will need to give ourselves some flexibility, but what is most effective is that we have regulators that can do what they need to do as the market evolves.”36

Regulator views

42.In oral evidence the FCA told us that activity-based principles would add significant complexity to the FCA’s work, and that the proposals could increase the risks of arbitrage that already exist around whether firms are within the regulatory perimeter or not. Edwin Schooling Latter told us:

There would be quite a lot of additional complexity for us, if a slightly different set of objectives, have-regards or considerations applied to different firms. If those differences in objectives and rulesets were based on type of firm, for example, we would create a regulatory arbitrage where a firm that is not in that category might find it easier to do business than a firm that is, because one is subject to those constraints and the other is not.

If it is done on the basis of activity rather than type of firm, we will probably have a slightly different problem, which is that firms may not be clear about whether the particular have-regard or objective is one that applies to them. […] It is simpler and more straightforward to have a single set of objectives and have-regards.37

Vicky Saporta agreed.38

Industry views

43.There were mixed opinions among the views we received from the financial services industry on this particular proposal. Those who had a view in general agreed that activity-specific principles would provide an opportunity for government and Parliament to set wider policy issues for regulators to have to consider. For example, UK Finance wrote that the proposal would:

Allow government and Parliament to ensure financial regulators have specific regard to public policy issues of relevance to the wider economy and society […] clarifying those issues of pressing concern to society that the regulators should more comprehensively consider in their activity would be a very positive development.39

44.However, there were notes of caution from some who were concerned about how the specific activities themselves would be defined. Legal & General told us that:

It may be more difficult in other areas of financial services, such as asset management, where defining “activities” may be more complex. It will be important to calibrate the level of granularity of such principles.40

The International Regulatory Strategy Group (IRSG - an advisory body to the City of London Corporation) agreed, stating:

There is an open question as to how broadly each “area of activity” will be set, the potential for overlap or insufficient delineation is significant. Whilst a number of “areas” such as insurance or particular types of market infrastructure have been quite clearly delineated, this has not been the case for, for example, asset management or other activities which have [for example] traditionally fallen within the very broad category of “investment business”. The benefits of delineating between different areas could be compromised if firms performing particular business models were caught by multiple areas of regulation simultaneously or if the categories were drawn too broadly.41

45.Barclays were in favour of activity-specific principles, citing the example of e-money accounts, which they said consumers were using as current accounts. They argued therefore that e-money accounts were the same activity as current accounts, but that the regulators were regulating them differently to the way in which they were regulating current accounts provided by banks. For Barclays, the suggestion of an activity-specific principle offered the opportunity for reform:

An activity-specific approach, based on the principle of ‘same activity, same risks, same regulation’, would ensure a more consistent regulatory approach with the same outcomes and standards for consumers.42

The European Union approach to regulation

46.Unlike the FSMA approach, which when introduced did not set specific rules for specific sectors of the industry, EU regulations for the financial services sector are set by specific types of activity, often referred to as “Files”. The rationale for such an approach is that without detail set out in law, there would be a greater risk of divergence between the interpretation of principles by the various national regulators across EU Member States.

47.Some have argued that the UK has benefited from a historically more flexible approach. Barnabas Reynolds, partner at Shearman & Sterling LLP and Global Head of the Financial Services Industry Group, drew our attention to a paper in which he argued that the UK’s more permissive approach to regulation, with less reliance on a set of rules that permit specific activities as seen within the EU regulations, is one of the reasons as to why the UK’s financial services sector has been historically more developed than those seen within the EU.43

48.However, the Treasury consultation stresses that:

In contrast to EU legislation, this activity-specific policy framework legislation would be high-level, focusing on the overall purpose, approach and key policy considerations relevant to each particular regulatory regime. It would not set the requirements that would apply to regulated firms, which would be the responsibility of the relevant regulators.44

49.It is not clear to what extent the Treasury wishes to implement activity-specific regulation. While the proposal is a key aspect of the Treasury’s future framework consultation, when we asked the Economic Secretary whether the Treasury intended to move more towards regulating by activity, he said it did not. We note, however, that the Financial Services Act 2021 already sets regulatory principles for the FCA to follow at an activity-based level in regulating investment firms, and it gives the Treasury a power under secondary legislation to specify further matters to which the FCA must have regard when regulating in this field. We conclude that the Treasury intends to pursue this policy irrespective of the findings of this consultation.

50.If done with a deft approach, there may be a role for activity-based principles or “have regards” to allow the Government to instruct the regulators, at a more micro level, how it wishes them to approach specific types of business sector. The Government can already instruct regulators more broadly on how to do this through remit letters. But the Government should be sparing in its approach: the strategic and operational objectives, combined with principles and “have regards” that are set out in their remit letters, are already numerous and expanding, to the point where regulators have to choose which to prioritise on a regular basis when drafting new policy proposals. The creation of too many activity-based principles would add a further layer of issues to which regulators must have regard.

51.Regulating a company as a whole rather than by activity carried out should provide greater flexibility to regulators to respond to new activities as they develop, rather than needing new activity-specific principles or frameworks each time a new activity emerges.

52.We will only be able to conclude with more certainty on the merits or risks of activity-based regulation once the Government provides more details on their proposals in its next consultation.

The Financial Ombudsman Service

53.The Treasury’s consultation states that the “proposed blueprint for the Future Regulatory Framework involves adapting the FSMA model to address the challenges of managing the on-shored regime and to create a more coherent and democratically accountable framework for the development and application of future UK financial services regulation”.45 However the consultation makes no reference to the Financial Ombudsman Service (FOS).

54.We have received written submissions urging that the FOS should be included in the Treasury’s framework review. The Finance and Leasing Association (FLA) explained how FOS decisions can set precedents that override FCA principles:

The Financial Ombudsman Service is an important part of the FSMA framework in delivering consumer redress. […] FOS decisions sometimes set a precedent where the FCA has not previously considered an issue or where its principles-based regulation has not been prescriptive. As the FOS makes its decisions based on the individual merits of each case, this creates the risk that further ‘regulation’ is created without taking into account wider considerations.46

In addition to setting precedents, the FLA also explained that its members are concerned that FOS decisions were inconsistent and did not seem to align with FCA rules.

55.UK Finance also noted that “where cases before the FOS have wider implications or would set precedents, there should be a more consultative and collaborative decision-making process with effective rights of appeal.”47

56.Decisions by the Financial Ombudsman Service set precedents and form a critical part of the consumer conduct-focussed element of the regulatory environment for financial services in the UK. Given that the aim of the Treasury’s consultation is to create a more coherent framework for how financial services are regulated, the Treasury should consider as part of this consultation how the decision-making processes of the Financial Ombudsman Service would interact with the future regulatory framework for the FCA.

57.If Parliament itself is to play a role in the setting the regulatory principles of the FCA, it needs to be satisfied that the principles which it has set the FCA are not being undermined by decisions by the Financial Ombudsman Service.