CHAPTER 2: Is reform necessary?
9. The fundamental purpose of the draft Bill
is to change the structure of regulation from the tripartite system
to a twin peaks model.
10. The preponderance of evidence suggested that
no regulatory structure however well designed can guarantee that
there will be no banking failures or crises in future. Our first
starting point has been that it is vital that legislation
makes proper provision for handling crises (including the ongoing
need for the lender of last resort function) and resolving bank
failures—including possible restructuring of banks to make
them more resoluble.
11. This legislation addresses how the Treasury,
the Bank of England and the regulatory authorities should co-ordinate
in a crisis and it goes some way to clarifying who is in charge
in a crisis. It also sets objectives to enable orderly firm failure.
It needs to be considered alongside the Special Resolution Regime
provisions in the Banking Act 2009, the Bank of England's duties
as Lender of Last Resort, and the ICB recommendations for the
ring-fencing of retail banking operations to make them more resoluble.
12. The financial crisis that began in 2007 had
an enormous economic, social and political impact on the United
Kingdom. It highlighted weaknesses with the tri-partite regulatory
structure. The FSA was severely criticised for inadequate regulation
and supervision of UK banks and wholesale capital markets, and
for failing to contain systemic risk.
13. The lack of proper prudential supervision
was only part of the problem. The run on Northern Rock in 2007
revealed major weaknesses in the process for crisis management
and in particular in co-ordination and division of responsibility
between the three players in the tri-partite system: the Bank,
the FSA and the Treasury. As the crisis unfolded, there was disagreement
about how to respond. The Rt Hon Alistair Darling MP, who
was Chancellor of the Exchequer at the time, wrote in his recent
autobiography that: "The whole system depended on the chairman
of the FSA, the Governor of the Bank and the Chancellor seeing
things in exactly the same way. The problem was that, in September
2007, we simply did not see things in the same way."[5]
14. The Northern Rock failure also revealed that
there was no satisfactory resolution procedure.[6]
15. Our witnesses were also overwhelmingly of
the view that the structure of financial regulation was not the
determining factor in how successful a country was in avoiding
or handling the crisis since 2007. Countries with unitary or twin
peaks regulation experienced problems on a similar scale to those
with tripartite systems like the UK. And the few countries which
appear to have best handled or avoided the crisis include those
with a range of different regulatory structures.
16. This evidence leads us to our second basic
starting point—that successful regulation depends more
on the regulatory culture, focus and philosophy than on
structure. A robust regulatory culture, focus and philosophy
is essential to ensure effective handling of risk.
17. Culture, focus and philosophy do interact
with the regulatory structure and the Bank of England believes
that combining conduct and prudential regulation in the tripartite
structure undermined focus and "directly contributed to the
FSA's taking its eye off the build-up of prudential risks in a
number of major institutions".[7]
Lord Burns, Chairman of Santander plc, told us that the "structure
created insufficient attention given to the prudential aspects
of financial stability, particularly with respect to capital adequacy
and liquidity management."[8]
18. As Mr Andrea Enria, Chairman of the
European Banking Authority, put it "We have to acknowledge
that during the crisis there were different types of construction
that equally succeeded or failed in the face of the crisis."[9]
19. For example Australia, which had a twin peaks
regulatory structure, weathered the crisis quite well. Dr Malcolm
Edey, Assistant Governor (Financial System) of the Reserve Bank
of Australia, believes that this was partly attributable to the
fact that "… the regulatory culture in Australia may
have been different from the one that prevailed in other countries
… Some regulatory cultures are more comfortable than others
with making use of softer powers. In Australia APRA would describe
itself as being towards the end of the spectrum; that is, it would
be more comfortable with using its persuasive powers and ability
to put pressure on institutions to try to influence the way they
behave."[10] He
went on to conclude that "Both the twin peaks and unified
central bank regulator models can be made to work. The most important
thing is how the regulators go about their task."[11]
This is supported by the experience of Canada, a country with
a unified regulator like the UK Financial Services Authority,
but which like Australia imposed comparatively strict bank regulations
(for example higher capital requirements than in other countries
and compulsory insurance for mortgages with loan-to-value ratio
of more than 75%). It is their stricter regulation of banks rather
than their regulatory architecture that explains why both Australia
and Canada were relatively unaffected by the global crisis.
20. In many other countries the predominant philosophy
amongst regulators was flawed. There was a presumption that markets
are perfectly rational which led the regulators to rationalise
the activities of market participants and assume that they did
not pose risks. This complacency is illustrated by the IMF Global
Financial Stability Report which stated in April 2006 a year before
the credit crunch erupted:
"There is growing recognition that the dispersion
of credit risk by banks to a broader and more diverse group of
investors, rather than warehousing such risk on their balance
sheets, has helped make the banking and overall financial system
more resilient.
The improved resilience may be seen in fewer
bank failures and more consistent credit provision. Consequently
the commercial banks may be less vulnerable today to credit or
economic shocks."[12]
21. In the UK the regulatory culture established
in the late 1990s was not focused on stability, probably because
the UK had not had a systemic banking crisis for a generation.
Also the main aim of the new structure was to create an independent
monetary policy committee and the system it replaced had focussed
on regulating financial services other than banking. Because nobody
was anticipating a major banking crisis:
(1) Responsibilities for preventing and managing
systemic crises were not clearly allocated.
(2) The focus was on the stability of individual
firms and there was no attention paid in the legislation to the
stability of the system as a whole.
(3) The focus was on regulation (i.e. the application
of rules once problems emerge, which was thought appropriate for
financial products and services), rather than supervision (i.e.
trying to anticipate problems before they happen, which is more
appropriate for ensuring banking stability).
22. This committee was conscious of the risk
of making the opposite mistake and focussing exclusively on systemic
stability to the neglect of other less topical objectives of the
regulatory system. The regulatory culture also failed to provide
rigorous conduct regulation. In recent years there have been a
number of cases of mass mis-selling of financial products to consumers.
The most high profile case was the mis-selling of payment protection
insurance but others include personal pensions, mortgage endowment
policies and split capital investment trusts. The financial industry
has had to make compensation payments of approximately £15
billion and this amount will increase considerably with much PPI
compensation yet to be paid. As the FSA itself acknowledges "a
new approach to conduct regulation is essential."[13]
23. The hope is that the reforms embodied in
the draft Financial Services Bill address the problems with the
tripartite regulatory structure by giving clear responsibility
for macro- and micro- prudential regulation, making it clear who
is responsible in a crisis and creating a separate expert conduct
regulator.
24. To be successful the reforms will have
to change the regulatory culture and philosophy. It is through
a change in culture and philosophy that the relevant authorities
can best ensure both financial stability and good conduct of business.
A key aspect of the cultural change needed will be a shift towards
forward looking supervision as explained in paras 188-198. This
will require staff with appropriate experience, approach and attitudes.
A change in culture is not something that legislation can guarantee
but legislation can influence the culture of a regulator by:
(1) setting objectives,
(2) allocating and aligning powers and
responsibilities,
(3) establishing appropriate systems of
accountability.
These are the three themes around which this report
is structured.
Without significant changes to clarify objectives,
allocate appropriate powers and create proper accountability the
Bill as currently drafted will not guarantee a change in regulatory
culture. This report makes recommendations to address these weaknesses.
25. It is also important to bear in mind that
UK reform cannot be considered in a vacuum. The financial sector
is global and crises may require a global response. This is recognised
in the work of the G20, the Financial Stability Board and the
EU. While shaping UK reforms, clarity is needed with regard to
the UK's powers vis-a-vis Europe and beyond.
26. Our remit was to consider the Draft Financial
Services Bill and therefore necessarily our recommendations are
mainly directed at the Government for proposals to amend the Bill
and at the regulators for how to interpret duties under the Bill.
This does not mean that we think it is only the regulatory culture
that need to change. The culture and ethics within the financial
services industry also needs to change. Before the 2007 crisis
many banks appear to have been involved in practices that were
unethical and designed to maximise remuneration regardless of
risk to the bank let alone the economy. Codes of ethics either
did not exist or were not adhered to and were certainly not enforced.
We heard some evidence that this is changing and banks are emphasising
ethics to their staff in particular to discourage excessive risk
taking. Developing the ethics of those working in the financial
services industry is the responsibility of each firm and should
be a high priority. The primary responsibility for the health
of a company lies with the Board and senior management as highlighted
in the very recent FSA report on the failure of the Royal Bank
of Scotland.
5 Back from the Brink: 1000 days at No 11, Alistair
Darling, Atlantic Books, 2011 Back
6
A resolution procedure is the procedure whereby the authorities
seek to manage the failure of an institution in a safe and orderly
way. Back
7
Bank of England written evidence Back
8
Q 35 Back
9
Q 91 Back
10
Q 104 Back
11
Q 105 Back
12
IMF Global Financial Stability Report, April 2006. Back
13
The FSA, the Financial Conduct Authority: approach to regulation,
June 2011, pg 1. Back
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