Draft Financial Services Bill - Draft Financial Services Bill Joint Committee

Draft Financial Services Bill - Draft Financial Services Bill Joint Committee Contents

CHAPTER 3: Objectives

27. The draft Bill creates three new bodies: the Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). The legislation needs to set out clearly the objectives of all three. This is essential to give each of them a clear focus; to ensure that there is no dispute about their respective responsibilities; and to provide a clear basis for their accountability to government and to parliament.

The objective of the FPC

28. The FPC is to be a macro-prudential supervisor. It will look across the financial system as a whole identifying risks to the stability of the financial system arising from excessive gearing, asset bubbles or the 'interconnectedness' of firms.

29. Under the Banking Act 2009 the Bank of England had an objective "to contribute to protecting and enhancing the stability of the financial systems of the United Kingdom".[14] Prior to this, the Bank considered financial stability but its responsibility for this area was only spelt out in the Memorandum of Understanding between the Tripartite Authorities.[15]

30. The draft Bill makes financial stability almost exclusively the responsibility of the Bank of England and its subsidiaries by dropping the words "contribute to":

31. The draft Bill further amends the Bank of England Act to establish the Financial Policy Committee whose objectives it defines as follows:

(1) "The Financial Policy Committee is to exercise its functions with a view to contributing to the achievement by the Bank of the Financial Stability Objective.

(2) The responsibility of the Committee in relation to the achievement of that objective relates primarily to the identification of, monitoring of, and taking of action to remove or reduce, systemic risks with a view to protecting and enhancing the resilience of the UK financial system.

(3) Those systemic risks include, in particular—

(i) systemic risks attributable to structural features of financial markets or to the distribution of risk within the financial sector, and

(ii) unsustainable levels of leverage, debt or credit growth."[17]

32. The drafting in Bank of England Act new clause 9C which requires the FPC to pay attention to systemic risks including "unsustainable levels of leverage, debt or credit growth" goes on to define debt and credit growth as "debt owed by" and "lending to" "individuals in the United Kingdom and businesses carried on in the United Kingdom". We cannot see why this limit to the United Kingdom is specified. British banks faced in 2007, and could again face systemic risks as a result of lending to, or debts owed by, individuals, businesses or, indeed, governments abroad. As drafted it would appear to exclude US sub-prime lending or Greek and Italian bonds from the categories of credit and debt which the FPC is required to monitor. It is true that the clause does not prevent the FPC looking beyond UK lending and debt but it does require the FPC to start with this narrow focus. This adds to the impression that the draft Bill has been written initially as if it applied only to the UK with at best a belated recognition that banking is a global industry. We recommend the Government reconsider the drafting of clause 3 (new Bank of England Act 1998 clause 9C(6)) to make clear the importance of monitoring the global exposure of UK banks.

33. Before and during the 2007 crisis regulators underestimated risks that were building up. These risks were sometimes greater than the sum of their parts due to interconnectedness between firms but this was not properly understood or monitored. In order to achieve financial stability the FPC must carefully consider the interconnected nature of the system. The reference in the FPC's objective to monitoring "systemic risks attributable to structural features of financial markets or to the distribution of risk within the financial sector" is presumably intended to place a duty on the FPC to consider the interconnected nature of the market—this duty should be made more explicit. An interim FPC has already been established and we were pleased to see that at its meeting on 16 June 2011 it observed that there are "vulnerabilities relating to the structure of the financial system itself. In particular, these related to interconnectedness in the financial system and to complex or opaque instrument structures with the potential to amplify or propagate any stresses that emerged".[18]

DEFINING FINANCIAL STABILITY

34. Assessing financial stability is difficult as it is nebulous and hard to quantify or define. It is not like inflation for which a numerical target can be set against which the Monetary Policy Committee's performance can be assessed. Lord Burns told us: "One of the problems is that measuring financial stability is a good deal more complex ... it is quite difficult for the Government to set an objective that is terribly precise."[19] The draft Bill leaves the term undefined.

35. Some witnesses argued there was a risk that the objective could be interpreted in an asymmetric manner. It could encourage the FPC to be overly cautious in pursuit of financial stability. Stuart Gulliver, chief executive of HSBC, said: "The way the FPC has been set up is that it is focused entirely on stability ... You could see a situation where everything has been secured to such an extent that there is no risk of a failure but there is no credit going into the economy either."[20]

36. Given the difficulties involved in measuring or even defining financial stability, Stuart Gulliver and others proposed changing the objective to maintaining a stable and sustainable supply of credit.[21] Barclays argued this is a more workable objective than trying to define financial stability itself. There is a twofold rationale for this: first, that excessive credit growth leads to overleveraging, asset bubbles and ultimately a financial crisis. Barclays wrote "We cannot think of a systemic risk that has no potential impact on the 'sustainable supply of credit'.[22] Conversely, in the aftermath of a banking crisis there is a danger of inadequate credit growth or even credit contraction if banks are required to restore their capital adequacy and do so by restricting or shrinking their lending. HSBC asserted that moving to a stable supply of credit objective would remove incentives for the FPC to be excessively conservative in such circumstances.[23] Second, the advocates of maintaining a sustainable supply of credit objective argue that the MPC sets a price for credit—the interest rate—but that has little effect on the supply of credit which should therefore be made the responsibility of the FPC using macro-prudential tools. They see the roles of the two committees as symmetrical. So, just as the Treasury sets the MPC an inflation target they believe it should set the FPC a target range for credit growth. And just as the MPC has to pursue its inflation target while "having regard for the government's growth and other objectives" so the FPC would have regard for those other objectives while meeting its credit target. Indeed, Stuart Gulliver suggested that "the Treasury should be setting out what the Government's goals are for growth, employment and job creation and saying to the FPC, "Use your macro-prudential tools to ensure that you achieve the Treasury's goals."[24] Both he and Bob Diamond cited the experience of Pacific economies who actively manage the flow of credit and even its sectoral allocation using a variety of macro-prudential tools.[25]

37. The British Bankers' Association also supported this approach. Other witnesses disagreed with an objective based on ensuring a stable supply of credit. Sir Mervyn King, Governor of the Bank of England, said such an objective would be unclear. Furthermore, credit supply is affected by many factors beyond the FPC's scope:

38. Sir John Gieve, former deputy governor of the Bank responsible for financial stability, also opposed the proposal: "That really would take you right into MPC territory. It would be very odd to have a separate committee charged with maintaining a sustainable supply of credit on one side and hitting an inflation target on the other, operating mainly by the regulation of credit."[27]

39. An unsustainable growth of credit is not the only potential source of financial instability. There are others including, in particular, inadequate bank capital and liquidity, the migration of exposures to maturity mismatch outside of the regulated banking sector to the wholesale financial markets and shadow banking and the network of interconnectedness revealed when Lehmans collapsed. These or other problems might trigger system wide problems even if bank credit has grown only moderately.

40. Preventing excessive or inadequate growth of credit will be an important part of the way that the FPC meets its objective. However, it will also need flexibility to consider other factors which bear on the stability of the financial system. Moreover, it would in our view be premature to attempt to set quantitative targets for credit growth before the FPC has experience of developing and applying macro-prudential tools. So we do not recommend setting a credit based objective for the FPC.

FINANCIAL STABILITY AND ECONOMIC GROWTH

41. As mentioned in paragraph 36, HSBC proposed that the FPC should be given an obligation mirroring that of the MPC "subject to [meeting its principal objective], to support the Government's economic objectives including those for growth and employment". The draft Bill does already require the FPC to take account of the impact of its policies on the financial sector's contribution to growth. It states that the FPC's responsibilities for contributing to the Bank's Financial Stability Objective:

Several witnesses suggested that this clause should be re-drafted to put the FPC under a positive duty to support economic growth.[29]

42. It is interesting to compare the drafting of the FPC objective to the MPC objective. Compared to the MPC formulation, where growth can only be considered subject to having delivered price stability, the FPC formulation places considerably higher priority to safeguarding growth. Ultimately the FPC will not be able to take decisions to promote financial stability if it believes those decisions risk medium to long term economic growth.

43. Mark Hoban MP, Financial Secretary at the Treasury, explained that the different remits of the MPC and FPC "means that it is appropriate that their objectives in relation to economic growth are formulated differently". The Treasury's position is that by meeting its primary objective of price stability the MPC will naturally support economic growth. In contrast the FPC's primary objective of protecting and enhancing the financial system could lead to decisions that have a negative impact on growth. Mr Hoban wrote: "The FPC therefore needs to strike a balance between making the financial sector safer overall without compromising sustainable economic growth in the long term."[30] The FPC's objective therefore features a stronger emphasis on growth to ensure that the FPC acts proportionately.

44. The Government is right to require the FPC to consider the impact of its decisions on growth. But the Bill's current drafting is too strong and restrictive. The FPC is not authorised to take any actions to promote stability if it is likely to have a significant adverse effect on the financial sector's contribution to growth in the medium or long term. The Bill should be redrafted so that like the MPC, the FPC must have regard to the Government's growth and other economic objectives subject to meeting its primary responsibility of attaining financial stability.

THE ROLE OF THE TREASURY IN INTERPRETING THE FINANCIAL STABILITY OBJECTIVE

45. The draft Bill provides that the Treasury will set and renew at least annually the remit of the FPC by making recommendations about how it should interpret and pursue the financial stability objective.[31] The FPC must respond to the Treasury's recommendations but in order to protect the independence of the FPC it will be able to reject the recommendations as long as it explains its reasons. The Treasury's proposals and the FPC's response must be laid before Parliament.

46. The draft Bill gives the Court of Directors of the Bank responsibility for setting the Bank's overall financial stability strategy and for renewing it every three years after consulting the FPC and the Treasury. The FPC will be required to take the strategy into account but has the right to make recommendations about it to the Court at any time.[32] This strongly reinforces the case for the Court to be replaced with a new Supervisory Board (see para 307).

47. The tools available to the FPC could allow a reversion to a level of central intervention in credit flows that has not been practised in the UK since the period of 'Competition and Credit Control' in the early 1970s. Such interventions would, for example, often affect mortgage availability and loans to households and companies. Given the wide range of possible interventions, and absence of any quantifiable target for financial stability corresponding to the inflation target for monetary stability, the FPC's decisions will be more politically controversial than those of the MPC.

48. It is right that the FPC will have the power to disagree with the Treasury's interpretation of the financial stability objective. However, the Treasury should have the power to override the FPC's objections otherwise the FPC would be constrained only by criticisms from the House of Commons Treasury Committee. Lord Burns said: "If there is any part of this set of proposals that concerns me, it is probably to do with the governance of the FPC in relation both to its accountability to Parliament through the Treasury and the extent to which it can be defined as 'independent'."[33]

49. We would address concerns about accountability of the FPC in two ways. We support the proposal of the Treasury Select Committee for the replacement of the Court of the Bank of England by a supervisory board to oversee the work of the Bank, and of the MPC and the FPC (see para 309). But while the supervisory board can provide independent assessment and review of the performance of the Bank, it cannot provide political oversight; that has to be exercised by either the executive or by Parliament. Therefore, in order to provide effective political accountability, the draft Bill should be amended so that the Treasury, not the FPC, has the final say about the interpretation of the remit of the FPC. We would normally expect the Treasury and the FPC to come to an agreement about the remit and therefore we would not expect the Treasury to have to override the FPC on a regular basis. If the FPC has any objections to the annual remit issued by the Treasury it should make these public and alert the House of Commons Treasury Committee. Notwithstanding that the Treasury may have suggested matters that the FPC should regard as relevant to the Committee's understanding of the Bank's financial stability objective the Bank of England remains responsible for the entirety of that objective.

INDICATORS OF FINANCIAL STABILITY

50. Professor Charles Goodhart of the London School of Economics advocated that the FPC assess financial stability against published indicators (to be chosen and justified by the FPC). These indicators would help the FPC in the pursuit of its objective. Marked movements in these indicators would mandate the FPC to explain to the House of Commons Treasury Committee its response.[34] In evidence to that committee Professor Goodhart wrote:

"Past experience suggests that there are a number of early warning indicators which tend to precede financial crises. These include the following:

(1) A rate of growth of (bank) credit which is significantly faster than average, and above its normal trend relationship to nominal incomes.

(2) A rate of growth of housing (and property) prices which is significantly faster than normal and above its normal trend relationship with incomes.

(3) A rate of growth of leverage, among the various sectors of the economy which is significantly faster than usual and above its normal trend relationship with incomes."

51. Professor Goodhart acknowledged that his proposed indicators were only suggestions and that the FPC "might have a completely different list". He suggested that the FPC should propose its own indicators and explain the reasoning behind each indicator in a published document.[36]

52. The Chancellor of the Exchequer was cautious about defining indicators at this stage:

53. The House of Commons Treasury Committee recommended that the Treasury should give guidance under Clause 3 of the draft Bill to the Bank of England to adopt indicators for gauging financial stability.[38] Recognising that thinking is still developing in this area it stated that the indicators should be flexible and open to challenge and review by parliament, government, the Bank and industry. The indicators would be published and the FPC would report against them at regular intervals.

54. Given that no one claims there is a known set of indicators that will provide a sure guide to the stability of the financial system it would be wrong to prescribe any in statute. Nor is it necessary to impose an obligation on the FPC to adopt a set of indicators of its own choosing. But we can see the attraction of having indicators of financial stability. The FPC should begin work towards developing indicators of financial stability in dialogue with the Treasury. They should be published and the FPC should report against them. The set of indicators should be flexible and subject to regular review.

FINANCIAL STABILITY AND RECOURSE TO PUBLIC FUNDS

55. As noted above the draft Bill amends the Bank's Financial Stability Objective so that it reads:

56. The Chancellor told the House of Commons Treasury Committee that his definition of financial stability included not requiring taxpayers' money to support the financial industry.[40]

57. Despite the Chancellor's view no mention is made in the Bank's financial stability objective of avoiding recourse to public funds. The Treasury Committee concluded this should be changed.[41]

58. We agree with the Chancellor that avoiding where possible the need for taxpayers' money to support or rescue parts of the financial services industry is a key element of financial stability. There will of course always be a possibility that public funds are called on to preserve stability but part of the objective of the FPC should be to minimise the likelihood of this happening. The FPC's objective should be amended to require it to "reduce the likelihood of recourse to public funds". We recommend a similar amendment to the PRA's objectives in paragraph 76.

POSSIBLE CONFLICT BETWEEN THE MPC AND THE FPC

59. How the decisions of the Financial Policy Committee and Monetary Policy Committee will interact is unclear. Influencing the amount of credit—as the FPC will do—will affect inflation. Changes in interest rates by the MPC will influence the amount of borrowing and, hence, financial stability. The Treasury admits monetary and macro-prudential policies "could move in opposite directions" but this "does not necessarily represent potential conflict between the actions of the two committees".[42]

60. In the July 2010 White Paper the Treasury gave the example of the build-up to the financial crisis, when interest rates were low—which encouraged excessive borrowing that made the financial system less stable—but inflation was on target so there was no case to increase interest rates. Had there been an FPC then it could have taken action to slow growth in banks' balance sheets and restrain borrowing. Depending on the macro-prudential tools used, such actions could have affected inflation and therefore the appropriate level of interest rates.[43]

61. The Treasury believes cross membership between the FPC and the MPC will help manage these interactions and avoid potential conflicts. The Governor and Deputy Governors for financial stability and monetary policy will sit on both the FPC and MPC.[44]

62. Furthermore, the Treasury suggests that there should be careful sequencing of meetings with the MPC being "the 'last mover', adjusting its analysis to take account of the likely impact of the most recent action taken by the FPC".[45] But it is unclear how much sequencing is needed: the FPC is scheduled only to meet every three months, while the MPC is scheduled to meet every month, meaning the MPC will have ample opportunity to respond as the last mover.

63. The Treasury said in its July 2010 consultation that further analysis on the interaction between monetary and macro-prudential policies will be needed when discussing what tools should be at the FPC's disposal.

64. Sir Mervyn King believes that the FPC will make the job of the MPC "easier" and found unconvincing the arguments that one committee may make the other's job more difficult:

65. If there is nonetheless any potential for conflict between the FPC and the MPC the key to avoiding it is good communication and co-ordination.[47] The British Bankers' Association suggested that the ability of members of the FPC and MPC to attend briefings from the Bank staff supporting each committee should also enhance coordination; they further suggested that members of either committee should have full access to information made available to the other. Fundamentally, however, the British Bankers' Association asserted that it is for the Chancellor to use his annual remit letters to the two committees to minimise any discrepancy in policy.[48]

66. Gillian Tett, US Managing Editor of the Financial Times, told us that the coordination of monetary policy and financial regulation was key to avoiding another crisis:

67. In our view, one risk is that more importance is attached to the MPC's work than the FPC's because the former has a quantifiable inflation target whereas the latter has a more nebulous target.

68. This risk would be reduced by implementing a recommendation from the House of Commons Treasury Committee to introduce a statutory duty for the Governor to raise any conflicts between the MPC and FPC with a new Supervisory Board (these recommendations are discussed further at paragraph 309). The Treasury Committee also recommended that the Governor should indicate how the conflict will be handled. This would force any conflict to be addressed and reduce the risk of the MPC being prioritised over the FPC.

69. Furthermore the risk should be reduced because interpretation and pursuit of the financial stability objective will evolve through the annual dialogue between the Treasury and the FPC. Over time this process should help ensure the FPC develops a statement of the interpretation and pursuit of financial stability that is consistent with the MPC's pursuit of monetary stability.

70. We do not expect any serious conflicts between the MPC and FPC but they may arise. Careful co-ordination and communication should minimise the risks as should the evolution of the FPC's interpretation of its objectives. On the rare occasions when the two committees might come into conflict the Governor should inform the Court—or the equivalent body if it is reformed—and the Chancellor, to explain how the conflict will be handled. Even if there is a difference of opinion the two committees must remain independently responsible for their own levers.

GOVERNANCE STRUCTURE OF FPC AND MPC

71. There are concerns about the different governance structures for the MPC and FPC.

72. The FPC will be a committee of the Court of Directors of the Bank whereas the MPC is a committee of the Bank itself. Barclays said that: "The FPC should, like the MPC, be a committee of the Bank rather than a committee of the Court of Directors of the Bank of England. At the very least, there should be shared membership of the independent non-executive members between the Court and the FPC. Otherwise, the FPC is only accountable to the Court through the shared executive directors of the Bank."[50]

73. The Bank of England has previously suggested that the reason for this arrangement is that the MPC is entirely responsible for decisions on monetary policy whereas the FPC will have to give directions to the PRA and FCA to use macro-prudential tools and the Bank executive and Court will make decisions on other financial policy matters (such as emergency liquidity assistance, lender of last resort etc). It will be the job of the Court to keep oversight of all the financial stability policy instruments distributed across the Bank and therefore the FPC will need to recognise the authority of the Court.[51]

74. We do not find these arguments convincing. Whether it is a committee of the Bank or the Court the draft Bill requires the FPC to take account of the strategy laid down by the Court. The governance arrangements in the draft Bill—where the FPC is a committee of the Court and the MPC is a committee of the Bank—risk giving the impression that one body is more important than the other. The FPC should be made a committee of the Bank.

The objectives of the PRA

75. The PRA's general objective is to "promote the safety and soundness of PRA regulated persons".[52] The draft Bill currently requires the PRA to meet this objective primarily by:

76. The second part makes it clear that the PRA is not expected to be a zero-failure regulator. Firms should be allowed to fail but the PRA will be responsible for seeking to ensure that failure will not have an impact on the stability of the financial system. We agree with that. We agree too that the primary concern of the PRA when regulating firms should be to prevent firms either in the way they carry out their business or if they fail from threatening the stability of the financial system.

77. But the Bill seems to make stability of the financial system the PRA's sole concern. It appears to absolve the regulator of any concern about the "safety or soundness" of firms it supervises if their failure would not pose a threat to the stability of the financial system as whole. This is unsatisfactory. The failure of a financial firm, even if it poses no systemic financial risk, can still place a burden on the Financial Services Compensation Scheme, seriously inconvenience customers, and—should any of its products and services not be covered by the compensation scheme—result in losses for customers and thus possibly also pressure for compensation by the taxpayer. This is why the prudential safety of individual firms is widely recognised as a separate regulatory responsibility, to be pursued alongside the 'macroprudential' function of promoting the stability of the system.[54] In practice the PRA will have a 'microprudential' responsibility as a result of EU directives. Since the draft bill does not state otherwise, the PRA supervisors will inherit from the FSA the responsibility for ensuring that UK firms comply with European directives known as Capital Requirements Directive IV (CRD IV) and Solvency II.

78. In order to align its objectives with its own activities and with international best practice, the Bill should explicitly give the PRA a microprudential objective alongside its concern with avoiding risks to the whole system. When supervising PRA regulated persons, the primary objective should remain to reduce risks to the stability of the UK financial system. The secondary objective should be to reduce potential costs of failure to the Financial Services Compensation Scheme, taxpayer funds and customers. Neither objective requires the PRA to be a zero failure regulator. The second objective will mean ensuring firms comply with rules on for example, capital adequacy, solvency and liquidity that will reduce but not eliminate the likelihood of failure.

SHOULD THE PRA HAVE REGARD TO COMPETITION?

79. The PRA is not currently required to have regard to the effect of its actions on competition in the financial sector. Certain witnesses have argued that this would be desirable. For instance, the Office of Fair Trading told us:

80. Sir John Vickers, Chair of the Independent Commission on Banking, said that it was "very important" for the PRA to have regard to competition, although he was not sure of the best way to achieve this.[56] One reasons Sir John gives is that "prudential capital requirements can be a barrier to entry, requiring newer and/or smaller banks to hold more capital for each unit of assets, and therefore raising their costs (holding all else equal)".[57]

81. On the other hand, Stephen Hester, Chief Executive of the Royal Bank of Scotland, told us that giving the PRA a duty on competition could muddy the waters between the PRA and the OFT: "it is just simply a choice of having one or the other. Abolish the OFT and give it to the PRA, or leave it with the OFT and don't give it to the PRA".[58]

82. The FSA opposed the suggestion of a duty on the PRA to have regard to its impact on competition, stating that the benefits of competition were uncertain in practice and, in particular, that introducing extra factors into the PRA's decisions would lead to trade-offs that could dilute the PRA's focus on prudential issues.[59]

83. Competition within the financial sector is an important part of developing a stronger, more diverse system. The actions of the PRA have the potential to affect the costs of individual firms or of particular types of institution, and affect the barriers to entry and expansion in the market. While the need to protect and promote competition in the sector should not dictate the actions of the PRA, nor detract from the clear role of the OFT in this area, we believe it is a factor that ought to be considered in the course of PRA decision making. We invite the Treasury to consider how best this duty could be included in the Bill.

THE PRA'S INSURANCE OBJECTIVE

84. In addition to its general objective the PRA is given an insurance objective: "Contributing to the securing of an appropriate degree of protection for those who are or may become policyholders".[60] The PRA will be responsible for the regulation of all insurers in the same way it will be responsible for all deposit takers. Mark Hoban MP, told us that this was appropriate because of the cross-over between insurance and banking, often within the same group, and the "complex on-balance sheet prudential issues" that affected both insurance and banking.[61]

85. The draft Bill sets out the PRA's insurance duties through a separate insurance objective: "contributing to the securing of an appropriate degree of protection for those who are or may become policyholders".[62] This reflects the correlation in this sector, especially in with-profits policies, between the management of risk and consumer outcomes. If our recommendations for new cross-sectoral objectives for the PRA are accepted then the need for a separate insurance objective will disappear. In case those recommendations are not accepted it is worth noting our concerns about the drafting of the PRA's insurance objective.

86. Consumer groups have suggested that the phrase "contributing to the securing of an appropriate degree of protection" does not place a sufficient responsibility on the PRA. Peter Vicary-Smith, Chief Executive of Which?, told us that the phrasing seemed to treat the consumer aspect of the PRA's with profits regulation as an "afterthought".[63] In response, Mark Hoban MP told us that the PRA objective had been defined in terms of making a contribution because the FCA's generic responsibility for consumer protection would also apply, meaning that the PRA was not solely responsible.[64]

87. The PRA also has a specific responsibility to secure "an appropriate degree of protection for the reasonable expectations of policyholders as to the distribution of surplus under with-profits policies".[65] The term 'reasonable expectations' is problematic. It has a legislative precedent in the (now repealed) Insurance Companies Act 1982. The FSA told us that under that Act the phrase "gave rise to a lack of clarity as to how those expectations were formed, what the substance of them was, and what actions the firm (and the regulator) should take in relation to them".[66] Indeed, much of the Equitable Life litigation revolved around the problems of defining the term. The FSA has said that the concept underlying 'reasonable expectations'— but not the phrase—has since been subsumed within the FSA's Principle 6 (Treating Customers Fairly Principle) and its rules on with profits policies.[67]

88. In the context of the draft Financial Services Bill, the FSA told us that although it supported the general policy aim, reintroducing the phrase 'reasonable expectations' risked "perpetuating this lack of clarity" and would be "an unfortunate retrograde step". Sir Mervyn King warned the House of Commons Treasury Committee in June that the term was "almost impossible to define for the regulator" and risked "leaving the regulator open to ex post judgements by others in court as to what it should and should not have done".[68] However, the Association of British Insurers told us that it was happy with the phrasing in its current form and that the phrase was "no more nebulous than this judgement-led approach".[69]

89. The Treasury has recognised the need for the FCA to advise the PRA on "matters relevant to achieving an appropriate balance between the interests of policyholders and the prudential position of the firm".[70] The FSA has stated that it will be "vitally important" for the PRA to have regard to the FCA's advice and make use of the FCA's expertise in consumer matters.[71] Under current provisions, this arrangement would be established under the memorandum of understanding governing co-ordination between the PRA and the FCA, but the Treasury has indicated it is considering "whether explicit legislative provision is necessary to ensure efficient and effective consultation".[72] The Association of British Insurers told us that conduct and prudential regulation of with-profits insurance were "completely joined at the hip" and that although the FCA should advise the PRA on these issues as a matter of course, it would be "safer" to have an explicit requirement written into the legislation.[73]

90. There is legal uncertainty regarding the definition of the "reasonable expectations" of policyholders. Using a phrase of this kind makes it difficult for the PRA to be clear on the meaning of its duties, and near to impossible for consumers and Parliament to hold the PRA to account for its actions. The phrase has been shown to be problematic in the past: it is unwise for the Treasury to revive it in new legislation and thereby risk the same difficulties recurring. The PRA should be responsible for ensuring that with-profits consumers are treated fairly, but the Treasury must find a way to redraft the Bill to achieve this end without using the problematic phrase "reasonable expectations". The PRA should be given an explicit duty to consult the FCA, as the consumer expert, on matters affecting with-profits consumers.

The objectives of the FCA

THE FCA'S STRATEGIC OBJECTIVE

91. As currently drafted, the FCA's strategic objective will be to "protect and enhance confidence in the UK financial system".[74] This will be complemented by three operational objectives:

· securing an appropriate degree of protection for consumers;

· protecting and enhancing the integrity of the UK financial system; and

· promoting efficiency and choice in the market for certain types of services.[75]

92. The FCA will also have a duty to discharge its general functions in a way that promotes competition, where appropriate.[76]

93. There was some support for this formulation of the FCA's objective. For example, HSBC said that "protecting and enhancing confidence in the UK financial system must be at the heart of its regulatory approach", and that "building confidence is the only way that we will achieve empowered consumers and well functioning markets".[77]

94. However, there has also been considerable criticism of the FCA's strategic objective to promote and enhance confidence. Criticism has focussed on the danger that it could require the FCA to bolster confidence by concealing or downplaying cases of consumer detriment. Few doubted the importance of promoting confidence—as long as it was warranted. Other criticisms of the strategic objective were that it does not reflect what the FCA is actually expected to do and that the meaning is unclear.

95. The purpose of the FCA is to ensure that business across financial services and markets is conducted in a way that advances the interests of all users and participants.[78] The FSA was concerned that this was not reflected in the FCA's strategic objective:

96. The ICB said that the practical meaning of the strategic objective was unclear, and that:

97. The OFT was also of the view that the strategic objective should not focus on confidence, and suggested the following wording: "making financial markets work well for their users". It thought that this would make it clear that competition is about achieving better outcomes for consumers and other users, and help ensure that the FCA will regulate in the interests of users and not market incumbents.[81]

98. The Treasury has indicated that it will revisit the FCA's strategic objective to better reflect the commitment to positive consumer outcomes while ensuring that the strategic objective remains sufficiently broad to cover the FCA's functions.[82] The objective of the FCA should not be focused on confidence. It is justified confidence in markets, not confidence per se that it important. Too much focus on confidence for its own sake could result in conflicts with the need to increase transparency in the market and protect consumers. The FCA's focus should instead be on making markets work well, which in turn should result in justified confidence in the market.

99. The FCA's strategic objective should be amended to focus on promoting fair, efficient and transparent financial services markets that work well for users. This would better reflect the Treasury's intended purpose for the FCA, which is to ensure that business across financial services and markets is conducted in a way that advances the interests of all users and participants.

EFFICIENCY AND CHOICE OPERATIONAL OBJECTIVE

100. With a strategic objective that focuses on markets working well, the FCA will need to promote competition, to the extent that it benefits users of financial markets.

101. The ICB recommended replacing the FCA's efficiency and choice operational objective with "promoting effective competition". This would be in addition to the FCA's duty to discharge its general functions in a way that promotes competition.[83] The ICB suggested that as currently drafted competition appeared to play a subordinate role to the strategic and operational objectives of the FCA.

102. The FSA told us that it favoured a similar solution to that recommended by the ICB although it proposed a slightly different wording: "promote effective competition for the benefit of consumers".[84] The words "effective" and "benefit for consumers" are helpful in that they reflect the fact that actions to increase competition per se do not always result in the best outcomes for consumers.

103. We recommend that the FCA should have a clearer role in promoting competition. To this end the FCA's operational objective of "promoting efficiency and choice" should be replaced by "promoting competition, efficiency and choice for the benefit of consumers". This will give the FCA a clear mandate in the area of competition and a clear responsibility for taking forward some of the ICB's recommendations aimed at making it easier for customers to move between retail banks and compare products.

104. If the FCA is to have a specific operational objective to promote competition, efficiency and choice for the benefit of consumers, then it is necessary to consider whether it will have appropriate competition powers and whether the right balance is struck between the FCA's competition powers and the OFT's responsibilities. This is considered in the next chapter.

THE DEFINITION OF CONSUMER IN THE FCA'S OBJECTIVES

105. As part of the consumer protection objective, the draft Bill[85] defines "consumer" in broad terms, covering both retail customers and wholesale and professional investors.

106. A number of witnesses, including the FSA's panels and Consumer Focus were concerned that the FCA's broad definition of consumer does not make sufficient distinction between retail and professional consumers, and this could encourage a "one size fits all" approach to regulation.[86]

107. Several financial firms were also concerned about the broad definition of "consumer". Barclays said: "A more specific and narrower definition of 'consumer' would be helpful."[87] Lloyds Banking Group said the Bill should include reasonable provisions to ensure that regulatory approaches are proportionate to the consumer, nature of the transaction and the product type.[88]

108. Clause 5 of the draft Bill[89] requires the FCA to have regard to:

· the differing degrees of risk involved in different kinds of investment or other transaction;

· the differing degrees of experience and expertise that different consumers may have.

109. Therefore, the FCA is expected to take a differentiated approach across different types of consumer and different contexts. This is particularly important, as it is clear that the right regulatory approach will differ depending on the needs and abilities of different types of consumers. Retail customers are generally less likely to have the same level of financial expertise as professional investors. This will mean, for example, that the way product information is presented to professional investors may not be appropriate for retail customers.

110. Mark Hoban MP argued in favour of retaining a broad definition of "consumer". This was on the grounds that it ensured that the FCA could discharge both its official listing functions, and its general functions to protect those persons who use the services of certain types of service-provider which do not carry on regulated activities but do provide key services to participants in the financial system:

111. Given that the draft Bill requires the FCA to tailor its approach to different types of consumer we believe the definition of "consumer" should remain broad and not be restricted to a narrower category.

BALANCING THE RESPONSIBILITIES OF CONSUMERS AND FIRMS

112. The FCA's consumer protection objective is the same as that of the FSA: "securing an appropriate degree of protection for consumers".[91] As set out earlier, in considering what degree of protection for consumers may be appropriate, the FCA must have regard to the differing degrees of risk involved in different types of transaction, and the degrees of experience and expertise that different consumers may have. It must also have regard to (amongst other things):

"(e) the needs that consumers may have for advice and accurate information;

(f) the general principle that consumers should take responsibility for their decisions."[92]

113. The consumer responsibility principle is also repeated under the regulatory principles[93] to be applied by both regulators, and which also include principles covering regulatory efficiency, proportionality and transparency.

114. Consumer groups objected to the consumer responsibility principle on the basis that not enough responsibility is placed on firms to ensure their products are "appropriate for the consumer in terms of meeting their needs, accessibility and reasonable value for money".[94] They fear that firms will continue "providing reams of documents for each product as a means of discharging disclosure requirements, in the hope that thereafter responsibility is transferred to consumers, as they 'should have read' these documents".[95]

115. Consumer understanding and financial literacy is also a problem. According to Consumer Focus, 5.2 million UK adults lack basic financial literacy, and some standard text accompanying loans requires PhD level education to understand.[96]

116. Professor Niamh Moloney of the LSE expressed the need for caution in applying the concept of consumer responsibility in the current environment:

"A combination of very limited investor ability to decode complex and detailed disclosures and to assess conflict of interest risk, largely unrestricted product development and duplication, and significant conflict of interest risk in the structure of the commission-based distribution sector, make the investor vulnerable to mis-selling.

117. As a solution, the Financial Services Consumer Panel suggested the consumer responsibility objective should be balanced by giving firms an explicit fiduciary duty towards their clients. The Consumer Panel said that:

118. However, some firms did not think that a fiduciary duty on firms would be appropriate, particularly given the broad definition of "consumer" that encompasses both retail and wholesale consumers. For example, Lloyds said of a fiduciary duty that:

119. The FSA said that it supported a principle on the responsibility of firms:

100

120. Consumer Focus, Which? and Citizens Advice suggested deleting the current consumer responsibility principle. They argued that if it is "considered essential that the FCA must have regard to the behaviour of consumers when it is pursuing its consumer protection objective" then the FCA's duty to have regard to the needs that consumers have for advice and accurate information and the duty to have regard to the consumer responsibility principle should be replaced with:

"(e) the needs that consumers may have for advice and information that is timely, accurate, intelligible to them and appropriately presented;

(f) the general principle that consumers are responsible for acting reasonably in their dealings with financial services providers and their intermediaries;

101

121. When asked if the consumer responsibility principle should be balanced by one for firms, Mark Hoban MP highlighted the principle in the draft Bill that senior management have responsibilities in relation to compliance with requirements imposed by or under the Financial Services and Markets Act.[102] When asked if firms have a duty to go beyond their technical legal responsibilities, Mark Hoban MP said: "It is in the interests of firms to ensure that consumers do understand the products that they are buying because it then minimises the risk of problems further down the track."[103] However, previous cases of mis-selling on a large scale—such as payment protection insurance, personal pension plans and mortgage endowment policies—indicate that it has not always been in firms' interests to ensure that consumers fully understand what they are buying.

122. We are especially concerned about problems caused by conflicts of interest, where the interests of a firm or adviser are not aligned with the best interests of its customers. An example is where an adviser receives commission from a product provider for recommending a particular product, regardless of whether it is suitable let alone the best product for a customer's needs. This is an area which the FSA has recognised as a problem and taken action: the FSA's Retail Distribution Review concluded that advisers who offer independent advice must do so free from any restrictions or biases, such as being paid by commission.[104]

123. We agree with Mark Hoban MP that financial capability needs to be improved[105], but financial education is a long-term process, and we are unlikely to see improvements in the short-term.

124. In connection with the consumer responsibility principle, Mark Hoban MP also said that:

106

125. We agree that the FCA will need to take a differentiated approach, as is currently reflected in the requirement for it to have regard to differing degrees of risk involved in different kinds of investment and transactions, and differing degrees of experience and expertise that different consumers may have. However, we are not convinced that this is sufficient to reflect the fact that in some cases, where products are very complex, and consumer understanding very limited, it will not be reasonable to expect consumers to take on a significant degree of responsibility for decisions without a corresponding responsibility on firms to ensure that products are appropriate and consumers understand enough to make well-informed choices.

126. We recommend that the consumer responsibility principle be complemented by an amendment to the draft Bill to place a clear responsibility on firms to act honestly, fairly and professionally in the best interests of their customers. The FCA should be empowered to hold firms to account for this and ensure companies address conflicts of interest and the needs that consumers may have for advice and information that is timely, accurate, intelligible to them and appropriately presented.

127. This is important because provision of information alone will not significantly improve consumers' ability to make well-informed decisions. The information needs to be easily understandable and accessible.

128. Clearly, the actions firms should be expected to take will depend on context and circumstances. For example, the way information is presented to retail consumers is likely to be different from that appropriate for a professional investor.

14 Banking Act 2009, Part 7, Section 238, Clause 1 (created new Section 2A in Bank of England Act) Back

15 Memorandum of Understanding between HM Treasury, the Bank of England and the Financial Services Authority 1997 Back

16 Clause 2(2) Back

17 Clause 3 (new Bank of England Act 1998 clause 9C) Back

18 Minutes of the interim FPC meeting on 16 June 2011 Back

19 Q 56 Back

20 Q 692 Back

21 E.g Barclays written evidence, HSBC written evidence, British Bankers' Association written evidence. Each witness suggested a slightly different version of an objective focussed on growth of credit. Back

22 Barclays written evidence Back

23 Q 692 Back

24 Q 693 Back

25 Q 692, Q 701 Back