Draft Financial Services Bill - Draft Financial Services Bill Joint Committee

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

CHAPTER 4: Responsibilities and powers

129. It is important to ensure that each body will have the necessary powers and duties to fulfil its objectives.

Responsibilities and powers during a crisis

130. The draft Bill reforms the respective roles of the Bank and the Treasury at times of crisis. The FPC will have a role in promoting stability to avoid crises, the PRA will have a role in anticipating any crisis by adequately preparing the resolvability of firms but once a crisis occurs the decisions will be made between the Governor and the Chancellor. The June White Paper described the roles of the different authorities in a financial crisis:

107

131. This is reflected in the draft Bill which states that:

"(1) Where it appears to the Bank of England—

108

(b) that such circumstances have arisen but no previous notification under this section has been given,

109

132. Clause 43 requires a Memorandum of Understanding (MoU) between the Treasury, the Bank of England and the PRA as to how they intend to co-ordinate the discharge of their functions in a financial crisis. A draft of the MoU was initially promised to aid pre-legislative scrutiny but publication has been postponed until after our deadline to report.

133. A key part of the MoU will define "material risk" of circumstances arising that could reasonably be expected to lead to the use of public funds. It will also explain how the Bank will notify the Treasury, what information the notification will contain, arrangements for keeping the Chancellor abreast of developments and the process of developing options to manage any risk to public funds.[110]

134. The House of Commons Treasury Committee recommended that material risk be defined in the draft Bill: "Definition is crucial—it determines what notice the Treasury will receive and therefore how much time it will have to prepare for a crisis and consider alternative causes of action."[111] That Committee was also concerned that material risk may become apparent too late. It recommended that the draft Bill "also require the Bank to give the Chancellor an early warning of the possibility that a notification of a material risk to public funds may need to be given, and full information about the circumstances".[112]

135. We are concerned that there is no duty for the authorities to co-ordinate in a crisis explicitly stated in the draft Bill. There is a requirement simply for an MoU. In other words, a duty to co-ordinate the exercise of functions in a crisis is imposed by requiring an MoU rather than by a duty in primary legislation.

136. We also share the Treasury Committee's concern about how much is being left to an MoU which will not be subject to parliamentary approval. The definition of material risk should be provided in a document of a legislative nature, subject to scrutiny by Parliament. The definition will determine whether or not an early warning system, as proposed by the Treasury Select Committee, is needed. If the bar is set sufficiently low for the material risk trigger no such early warning system would be needed.

137. The fact that the MoU may be revised from time to time is also of concern. There would be nothing to place any constraint on how it could be revised should it prove inconvenient. Those liable to be affected by it could therefore never be sure that it would be applied in the form in which it has been previously published.

138. Although it is intended that the MoU will define material risk it is not clear that the Treasury's view of what is a material risk is relevant: the duty in clause 42(1) is triggered simply by the Bank considering that there is a material risk.

139. Our final concern is that the draft Bill suggests there may be circumstances when a material risk has arisen but the Treasury is not notified (see sub-section (b) of clause 42).

140. The powers and responsibilities of the Bank of England and the Treasury during a crisis are key. They should be carefully reviewed in light of the concerns we have raised. A duty for these bodies to co-ordinate in a crisis should be on the face of the Bill. The definition of the term "material risk" should be subject to parliamentary approval and not left to a Memorandum of Understanding. The Bill should also make it clear that there are no circumstances where it is permissible for the Bank not to notify the Treasury as soon as material risk to public funds becomes clear.

141. In addition to its recommendations on material risk the House of Commons Treasury Committee recommended that the Chancellor should have statutory responsibility for a crisis after the formal notification of a material risk to public funds and that notification would automatically trigger a "discrete power for the Chancellor to direct the Bank". The Chancellor would be able to choose to use this power at any point after receiving an early warning of material risk to public funds.[113]

142. It is sensible that the Chancellor should have the power to direct the Bank at times of crisis. The Chancellor is ultimately accountable for the handling of a crisis and he should have powers commensurate with that accountability. The Bank of England Act 1946 does already provide such a power stating that the Treasury "may from time to time give such directions to the Bank as, after consultation with the Governor of the Bank, they think necessary in the public interest".[114] No Chancellor has ever used this power because of the effect it would have on confidence in the financial system. Alistair Darling was tempted to use the power in 2007 but decided that "a public row between myself and Mervyn would have been disastrous".[115] An automatic trigger of a power to direct the Bank might lessen the risk that using the power would provoke a crisis of confidence.

143. The Bill should be amended so as automatically to give the Chancellor power to direct the Bank after a formal warning of a material risk to public funds. At this stage ultimate responsibility rests with the Chancellor.

Powers and duties of the FPC

144. In pursuit of its objective the FPC will need specific powers to identify, monitor, and take action to remove or reduce, systemic risks.

POWERS TO IDENTIFY AND MONITOR SYSTEMIC RISKS

145. The FPC has a duty to police the PRA's regulatory perimeter and make recommendations to the Treasury if changes are needed. The draft Bill gives the Bank of England—and by extension the FPC—the power to require that the PRA or FCA provide it with information that the two bodies hold or are empowered to demand from the firms they regulate.[116] However, the Bank wants to be able to collect information directly from firms outside the regulatory perimeter. Sir Mervyn King explained:

117

146. The PRA does have some powers to gather information from firms outside the regulatory perimeter. A 2010 amendment to the Financial Services and Markets Act gives the FSA,[118] (and by virtue of the draft Bill the PRA) the power to demand specific information to a specified timetable from certain classes of people outside the regulatory perimeter. These include anyone involved in running an "investment fund" as long as the information might be "relevant to the stability of one or more aspects of the UK financial system".[119] But in addition the Treasury may by order extend the category as widely as it chooses—if the Treasury is convinced that the activities the information concerns meet the stricter test that they "pose, or would be likely to pose, a serious threat to the stability of the UK financial system". [120]

147. Sir Mervyn King proposed an amendment that would give the FPC a wider power to collect information from outside of the regulatory perimeter (the drafting of the amendment would also enable it to collect information from within the regulatory perimeter).[121] He proposed that the FPC should have a power to gather information from any "person where the Bank considers that the activities carried on by that person, or the way in which those activities (or any part of them) are carried on, are or might be relevant to one or more aspects of the UK financial system".[122] The FPC would therefore not only have the power to gather information from more or less any person, unlike the restricted categories set for the PRA, but would also be able to do so without meeting any test of the activities presenting a "serious threat" to financial stability. Safeguards are important—a wide power to collect information from an unspecified group of unregulated businesses could be considered draconian.

148. We are sympathetic to the need for the FPC to have powers to collect information from those outside the regulatory perimeter. In fact the FPC will normally be able to obtain the information it needs through the PRA but sometimes this might cause delay. The FPC should be given a reserve power if it thinks that requesting the information indirectly through the PRA could cause delay or have adverse consequences.

POWERS NEEDED TO REMOVE OR REDUCE SYSTEMIC RISKS

149. In pursuing macro-prudential policy the FPC will have the following levers:

(i) public pronouncements and warnings to raise awareness of issues which may lead to market-led solutions;

(ii) influencing macro-prudential policy in Europe and internationally;

(iii) making recommendations to bodies other than the PRA and the FCA, including about the regulatory perimeter to the Treasury;

(iv) a broad power to make recommendations about anything it believes relevant for financial stability to the PRA and FCA. This will be supported by a statutory requirement for the PRA and FCA to either comply with the recommendation as soon as practicable or explain in writing to the FPC why it has not done so; and

(v) the power to direct the two regulators where explicitly provided for in secondary legislation subject to Parliamentary approval.[123]

150. The macro-prudential tools are not specified in the draft Bill. They will be granted via secondary legislation.

151. Under the ICB proposals retail banking would be ring-fenced from riskier investment banking activities. The ICB report stated:

124

152. Some macro-prudential tools will involve adjusting capital ratios which the ICB proposes to increase sharply above internationally agreed Basel III ratios. The ICB has recommended that large retail banks should hold equity capital of at least 10% of risk-weighted assets, compared to 7% in Basel III. Furthermore, a leverage ratio—which makes no adjustment to assets for risk —should be at least 3% for all banks.[125]

153. Under Basel III the 7% equity capital ratio has two components: 4.5% is the absolute hard minimum plus an additional 2.5% which is the capital conservation buffer. If a bank holds capital of between 4.5% and 7% supervisors will restrict dividends and bonuses to preserve capital.[126] As most bankers do not want anyone meddling with bonuses and dividends it is expected that in normal times they will want to keep equity capital above 7%. But if equity capital falls below 4.5%—the hard minimum requirement—this "would make a bank non-viable", according to the ICB, which risks the bank being put into resolution. The Commission's final report explained:

127

154. The effectiveness of capital adequacy requirements has been questioned. For example, capital adequacy requirements may not constrain credit expansion during an upswing as banks will find it relatively easy to acquire additional capital and therefore would not prevent lending excesses and asset price bubbles of the type seen before the 2007 financial crisis. This underlines the importance of ensuring the FPC has access to a wide range of tools and sufficient expertise to make informed judgements about the appropriate tools to use (see para 325). It will be correspondingly important to give Parliament a proper chance to scrutinise the instruments that grant the FPC macroprudential tools (see para 315) and to undertake detailed pre-legislative scrutiny of the legislation that will be brought forward to enact the ICB recommendations (see para 8).

POWER OF DIRECTION

155. The FPC will have a broad power to make recommendations about anything it believes relevant for financial stability to the PRA and FCA. The PRA and FCA have either to comply with the recommendation or publicly explain why they will not.

156. For a narrower range of pre-specified macro-prudential tools the FPC will have the stronger power to direct the PRA and FCA to implement them. The PRA and FCA must comply with these directions. But the exact timing and means of compliance is up to the PRA and FCA. The FPC can only recommend, not order, the timing and means. For example, one possibility is that the FPC could have the power to direct the PRA to raise banks' capital ratios to a minimum of X%, recommending this be done within three months. The PRA would have to increase capital ratios to X% but may choose to do this over six months, not the recommended three, as long as they explain why.

157. The Bank believes a stronger power of direction would be better. Sir Mervyn King said:

128

158. Sir Mervyn suggested an amendment to allow the FPC to "require or recommend its provisions to be implemented by specified means or within a specified period".[129]

159. The Financial Services Authority supported this amendment:

130

160. Related to this is the issue that the PRA or FCA may have to make a new rule in order to implement a macro-prudential tool. Like the FSA, the PRA and FCA will normally be expected to publish cost-benefit analyses of draft new rules and hold consultations before implementing them. In these circumstances the regulators would need flexibility on timing in order to consult. The draft Bill allows for the Treasury to "exclude or modify any procedural requirement that would otherwise apply under FSMA 2000"[131]including consultation. The requirements would be disapplied in the Order granting the FPC the power to direct over a certain macro-prudential tool. It is important that this should happen no more often than absolutely necessary.

161. Where the FPC is to be given the power to direct the PRA and FCA to implement a macro-prudential tool it should also be given the power to direct the regulators as to the timing and means of implementing that tool. The FPC should use this power where the timing and means of implementation are likely to have a significant impact on the effectiveness of the tool. If these circumstances do not exist the decisions about timing and means are better left to the regulators— the PRA and FCA—who hold the expert knowledge.

POWER FOR THE FPC TO SET UK MACRO-PRUDENTIAL RULES

162. The European Commission's proposals for Capital Requirements Directive IV are intended to implement the Basel III accord: a set of minimum capital requirements drawn up by a committee of central banks from major economies around the world. Basel III does not restrict a country's ability to impose higher capital requirements than the minima specified. The Treasury and Bank of England are concerned that the current draft of the Directive contains important differences from Basel III that would restrict how much the UK could raise capital requirements over and above the new 7% ratio of equity capital to assets.[132] They fear it may prevent Britain imposing a 10% minimum on large British retail banks, which has been recommended by the ICB or limit the scope for implementing countercyclical capital requirements.

163. In May, Sir Mervyn King said:

133

164. Andrea Enria told us that since May, the draft directive has been amended to remove ceilings on the capital requirements member states can impose:

134

165. Andrea Enria added that the directive now provided enough flexibility for the UK to introduce the higher capital requirements recommended by the Independent Commission on Banking. However, he went on to say:

135

166. We believe that Andrea Enria's claim that the regulation will allow the UK flexibility to implement the ICB's recommended capital requirements is contradicted by his admission that it will be subject to EU scrutiny. Asked if he meant that any increase in UK capital requirements would need clearance at a European level Andrea Enria appeared to say 'yes'—despite not liking the word 'clearance':

136

167. Despite the July amendments to the directive, Sir Mervyn King remains concerned. In November he told us:

137

168. Sir Mervyn King also disputed Andrea Enria's concerns about capital redistribution if one country unilaterally increases its capital requirements:

138

We concur with this analysis and find Mr Enria's justification for setting an upper limit on capital requirements unconvincing.

169. Asked how confident he was, on a scale of one to ten, that the European consultations would deliver British authorities the flexibility they need, Lord Turner answered:

139

170. The Chancellor told us:

140

171. The current draft of the Capital Requirements Directive IV appears to allow member state authorities to take into account "structural variables and the exposure of the banking sector to any other risk factors related to risks to financial stability".[141]

172. We welcome the language in the proposed Capital Requirements Directive IV that appears to allow member state authorities to take into account "structural variables and the exposure of the banking sector to any other risk factors related to risks to financial stability". Nevertheless, the Government must continue to push for the removal of all restrictions on the ability of member states to raise their capital requirements above internationally agreed minima. Such freedom to impose higher capital requirements is essential given the large size of Britain's banking sector relative to its economy.

173. There is also an essential need to be able to run capital down in a crisis. Simply raising capital requirements without allowing capital to be used as a loss absorbing buffer, often results in contraction of assets and a reduction in credit. Stuart Gulliver explained:

142

174. This is equally a problem for insurance companies under the new European Solvency II regime as it is for banks.

175. The FPC and the PRA should consider carefully what actions they will take with regard to capitalisation and liquidity requirements in the event of another crisis and must consider to what extent they are currently constrained by European regulation and how far this represents a threat to the UK's ability to respond to any financial crisis. Where they assess that they are constrained by European regulation they should report this to the Treasury and to the committee that we recommend at para 305 as being responsible for co-ordinating international representation on these type of issues.

Powers and responsibilities of the PRA

POWERS IN RESPECT OF FIRMS HEADQUARTERED OUTSIDE THE UK

176. Many of the firms which the PRA will regulate will be headquartered outside the UK. The PRA's supervisory approach will be based on the principle that all banks, both UK and overseas, operating in the UK "should be subject to the same prudential requirements. The PRA's focus will be on the impact which a firm's failure might have on the stability of the UK financial system, regardless of the location of its ultimate parent and legal form."[143]

177. The PRA's powers over international banks will be determined by the legal form which a bank takes in the UK:

· Subsidiaries of overseas banks—the PRA's prudential powers will be the same as for a UK headquartered bank. The PRA will need to assess the UK firm's links with its parent company and the viability of the group as a whole, so supervision of overseas activities will be relevant. The PRA would expect to be on the college of regulators of the parent firm. International firms that carry out investment banking business in the UK will be particularly hard for the PRA to regulate. It may be difficult to ensure orderly resolvability of the subsidiaries of international investment banks given the interconnectedness of their business with their operation elsewhere. The PRA will have to work with the supervisory college to maximise cross-border co-ordination.

· Branches of overseas banks—EEA headquartered banks have the right to passport branches into the UK. During the crisis, EU law provided inadequate safeguards for EEA host state authorities to ensure that the branch operations of EEA banks were complying with EU prudential regulatory requirements. This was a particular problem for UK authorities in overseeing the UK branch operations of Icelandic banks where the Icelandic authorities had failed to ensure they were complying with EU capital and liquidity requirements. We therefore welcome the proposal within CRD IV that affords host state supervisory authorities with significant oversight powers to require all EEA branches to report to them periodically on their activities in the host member states and to demonstrate that their UK branch operations comply with EU prudential regulatory standards. However, EU bank insolvency law remains firmly anchored to the principle of home country control, which makes it impossible to resolve an EEA branch in the UK separately from the rest of the firm.

178. The PRA's powers to supervise the UK operations of EEA branches are therefore limited but will be strengthened under proposals contained in CRD IV. In 2010 it was calculated that these branches held around £2 trillion of assets in the UK. The PRA will "seek to influence, through collaboration and in a supportive manner, the supervisory approach of the home state at group level". It will "wherever possible" obtain evidence that home regulators have sound resolution plans.[144] For all major banks with significant branches in the UK the PRA should be on the college of supervisors for that bank.

179. In reality the PRA's main power will be to make public its limited role in regulating these firms and to work with the FCA to ensure that consumers understand that deposits in passported banks are not covered by the Financial Services Compensation Scheme. The PRA has said that where it does not have much information "it will make that understood publicly so that there is no misunderstanding about what it can do and so that it is clear to depositors that they are not protected by the home state regime".[145]

180. Even though the PRA may under CRD IV gain limited powers to oversee the UK operations of EEA firms these will remain ultimately the responsibility of their home state regulator. The PRA and the FCA should seek to ensure that the public understand when a banking group is not subject to UK prudential regulation. Where deposits are not covered by the Financial Services Compensation Scheme the regulators should require banks to make this clear with prominent warnings in branches and on websites. The regulators should work with consumer groups to plan how best to get this message heard and understood.

181. There is a further way that the PRA's powers will be limited in respect of firms operating in the UK and the EEA. The Bank of England and FSA state that the establishment of the new European Supervisory Authorities and the European Banking Authority "provides an opportunity for the PRA to influence further the supervision of incoming EEA branches".[146] This is true and in para 305 we set out how we hope the UK regulators will maximise their influence at a European level. However, the European Supervisory Authorities will also have powers to direct the PRA (and the FCA) to act in certain circumstances. For example, the European Supervisory Authorities will be able to direct the PRA and the FCA if there is a disagreement between two of the EEA regulators in respect of a firm operating in both their countries. So for example if the UK and German regulators disagreed about the requirement that should apply to a bank headquartered in Germany but passported here, or a bank headquartered here but passported in Germany, then either the UK regulator or the German regulator could refer the issue to the European Banking Authority for mediation. The European Banking Authority would then have discretion to mediate and in some circumstances to issue a binding decision on the national regulators. There are different interpretations as to when the EBA could issue a binding decision.

182. The PRA will be under a duty to co-ordinate with international regulators.[147] This is an immensely important duty given the international dimension of many of the firms whose failure could impact on the stability of the UK financial system. In order that the PRA can be effectively held to account for its duty to co-ordinate with international regulators we recommend a further duty to report on its work in this area.

THE IMPACT OF ICB RECOMMENDATIONS ON THE PRA'S RESPONSIBILITIES

183. It is hoped that the PRA's approach of enabling orderly firm-failure will be aided by the ICB's recommendations on ring-fencing the retail operations of banks. The Banking Act 2009 provided a resolution regime for UK deposit-taking banks/building societies along with an enhanced financial compensation scheme. This addressed the Northern Rock problem where a medium-sized—mainly deposit-taking—bank failed and the UK authorities (rather than rely on an inadequate insolvency law regime) guaranteed all of Northern Rock's deposits and later nationalised it. However, after the Banking Act 2009 was adopted, Andrew Bailey, Deputy Chief Executive-designate of the PRA, stated that the Act still could not handle the failure or resolution of a too-big-to-fail universal UK bank.[148] The Banking Act 2009 worked well with Bradford and Bingley and Dunfermline Building Society; but it was recognised as being inadequate to handle the resolution of Barclays, Lloyds or RBS etc.

184. In order to avoid a 'no-failure' regime for too-big-to-fail universal banks, the ICB proposes to regulate the structure of the universal banks with ring-fencing and an enhanced regulatory capital charge. Ideally, the PRA would apply the ICB recommendations so that the Banking Act's 2009 resolution regime could be applied to allow an insolvent too-big-to-fail universal bank to fail without imposing a direct cost on taxpayers. We think that ring-fencing retail banking is a necessary step but whether it will be sufficient to address the too-big-to-fail issue remains to be seen. If it does not prove sufficient then the Bank of England will still need to be ready to step in and support banks as Lender of Last Resort in order to protect the stability of the financial system.

185. The ICB recommended that the ring fencing proposals should be put in place soon but it recognised that its recommendations on additional capital requirements would take longer to prepare for and therefore suggested that they should be implemented no slower than Basel III (so no later than 2019). HSBC said that meeting the ICB's capital requirements across the group, not just in the UK, would require the issuance of bonds to finance the purchase of gilts which could lead to an estimated annual carrying cost of US$2.1 billion after tax.[149] The Treasury has now confirmed that this draft Bill will not be the vehicle for those changes. The ICB recommendations are key to the work of the regulators established by the draft Financial Services Bill. For example, without the ICB reforms it will be harder for the PRA to meet its objective of minimising the impact of firm failure. The legislation enacting the ICB recommendations on ring-fencing should be introduced into parliament during the 2012-13 Session in order to give banks a clear framework to work to. The ring-fence should be implemented speedily. By contrast there is a good case for allowing banks to build up capital over time. Furthermore, the Government should think carefully about imposing on banks headquartered in the UK capital requirements relating to their overseas subsidiaries over and above that agreed by the international college of regulators monitoring those banks.

186. Once in place, the ICB's recommendations on ring-fencing the retail operations of banks will place considerable additional responsibilities on the PRA which will have to supervise the ring fence. How this will work will be a matter for separate legislation but it is worth flagging-up a concern Sir Mervyn King raised about whether that legislation will give the PRA a role in defining the ring fence:

150

151

187. It should be for Parliament to define the ring-fence for retail banking. The definition may need adjusting from time to time and therefore should not be enshrined in primary legislation. Instead it should be set out in secondary legislation so it can be more easily reviewed and adjusted. It should not be left to the Bank or the regulators to define the ring-fence.

EMPOWERING THE PRA TO CONDUCT JUDGEMENT-LED SUPERVISION

188. The Treasury intends that the approach of the two new regulatory bodies will be "judgement-led". The Chancellor sees this as one of the key objectives of the reforms:

152

189. Although ministers and regulators have been very vocal about the importance of the new judgement-led approach, the term is not referred to or defined in the legislation and no specific powers are given.

190. Hector Sants offered a helpful explanation of judgement-led supervision:

"All regulation has an element of judgment. The question is the degree to which that judgment is based on hard, observable facts as opposed to the degree to which it is based on a view as to what might happen in the future.

153

191. The FSA already has, and exercises, powers that allow it to place different requirements on different firms depending on an assessment of the risks they pose. For example, the FSA can vary the permission a particular firm has to carry on a regulated activity. This power can be used to limit the activities the firm carries on or to require a firm to do, or not to do, a particular thing. So if the FSA told a particular firm to hold a certain level of capital and that firm did not comply, then the FSA has the power to remove or restrict the firm's permission or require it to comply on the basis of an assessment of risk. The key difference is that the PRA and FCA will be expected to use these powers in a more forward looking way.

192. The Bank of England is concerned that the Financial Services and Markets Act framework will constrain judgement-led supervision. When we visited the Bank on 21 November (see Appendix 5) Sir Mervyn King told us that the Act was designed to be a piece of compliance regulation and that it will be a real challenge to amend it to become a piece of legislation which promotes judgement-led supervision.

193. Paul Tucker, Deputy Governor (Financial Stability) of the Bank of England, suggested introducing a duty on the PRA to supervise. This would be different from the FSMA duty to ensure compliance with the rule book. Schedule 1ZB of the draft Bill places a duty on the PRA to maintain arrangements designed to enable it to determine whether persons it regulates are complying with relevant requirements. The Bank would like to see this amended to place a duty on the PRA to maintain arrangements that allow it to supervise firms. Paul Tucker suggested this would be key to empowering the Bank to make judgement based decisions. In para 78 we recommended that the objectives of the PRA be amended to distinguish between its two distinct duties of monitoring individual firms to contribute to system wide safety and monitoring individual firms to ensure that they have robust prudential plans in place. The FSMA duties are still relevant to the second objective of prudential regulation of individual firms. Thus the duty on the PRA could be to maintain arrangements allowing it to (a) determine whether a person it regulates complies with relevant requirement; and (b) monitor and where appropriate intervene in the actions of regulated persons in order to avert systemic financial risk.

194. Key to the regulators' approach are the threshold conditions contained in Schedule 6 of the Financial Services and Markets Act. These set out what firms must do to become, and remain, authorised. The Bank told us "Together with the regulator's statutory objectives, the threshold conditions form the basis on which the regulator will determine and enforce its supervisory judgments." The Financial Services and Markets Act applies a single set of criteria to all firms. The Bank believes the current criteria are too general and will not allow supervisors to use judgement to assess prudential risks. The Bank therefore proposes that the threshold conditions be amended so that banking institutions and designated investment firms on the one hand, and insurers on the other hand, should be subject to threshold conditions designed specifically for their type of business.[154]

195. The Bank's proposed amendment to threshold conditions would represent a very significant change in the authorisations process for firms. It is arguable that such a significant change should be consulted upon. If such changes were put in place then there would be complicated questions to address such as whether the authorisations of all existing firms would need to be reviewed in light of the new, and significantly different, threshold conditions. There may also be risks to being too specific about the threshold conditions for each type of business in primary legislation given that flexibility may be helpful. Nevertheless it is clearly important that the threshold conditions embody all the things that the PRA might want to take into account when deciding whether to authorise a firm. An authoritative list of all the things the PRA will consider during the authorisation process would be a useful tool for supervisors.

196. Forward looking supervision is a desirable aim. Mechanical enforcement of rules should not be the objective of the regulators. We agree with the Bank of England that more needs to be done to ensure the PRA has the legal power to supervise using forward looking judgement. As a first step the Bill should be amended to place a duty on the PRA to supervise firms. The Treasury should then consider how to enshrine in the legislation the concept of forward looking supervision. In particular, the threshold conditions which set out what firms must do to become and remain authorised should be carefully reviewed to ensure that they embody all the things that the PRA may wish to consider in a forward looking regime.

197. There has been concern and uncertainty about what forward looking supervision might mean for firms. Once established, the new regulators should provide clarity on this issue. A less predictable approach means that regulators will have greater discretion and it is therefore important that attention is paid to the proportionality principle.

198. Forward looking supervision does not sit easily with the moves within the European Union towards a more rules based and harmonised approach to financial regulation. CRD IV and Solvency II will both create more regulations in this area and a single EU rulebook, achieved through binding technical standards issued by the ESAs, should not limit the necessary discretion of UK regulators to move away from compliance towards judgement. This is a risk to the forward looking approach and it should be kept under review. The new committee which we propose be established to agree objectives and maximise the UK's influence in EU and international negotiations (see para 305) should have as an objective ensuring that the European rulebook does not limit the necessary discretion of the UK supervisory authorities to achieve forward looking regulation.

ATTRACTING THE RIGHT STAFF

199. Forward looking supervision is a key cultural change for the regulators and it will require a different approach and skillset. Effective judgment led regulation will require intellectual capability, an understanding of the complexities of financial markets and a willingness and confidence to challenge senior staff within firms. The lack of senior, experienced regulatory staff able to exercise judgment in an increasingly complex financial services market may constrain a shift in this direction.

200. Several witnesses suggested that the regulators would need to offer substantially better pay and conditions to attract the quality of staff needed. There is a considerable asymmetry between the pay and conditions of those who work in the financial services industry and those who regulate it. Highly skilled individuals with knowledge of the system are likely to be attracted by jobs which pay considerably more than the regulators. Sir Mervyn King stated that this was not always the case and that some very good people were attracted to a public service career specialising as a regulator.[155]

201. The PRA and the FCA will need to attract staff with the appropriate approach and experience if the required cultural change is to be realised. There is considerable debate, which we cannot resolve, about how this can be achieved within the financial constraints of public sector bodies. The PRA and the FCA should publish practical plans that explain how they will ensure that they have staff with suitable skills and how they will develop careers for financial regulators in the public service. They should report against progress in this area in their annual reports.

Designation of PRA activities

202. The draft Bill does not define the activities to be regulated by the PRA. Instead it provides for this designation to be made through secondary legislation.[156] The FPC will be responsible for monitoring the regulatory perimeter, with input from the PRA and FCA, and for recommending changes to the Treasury.[157]

203. The Treasury has signalled that at least initially firms carrying out the following activities will be regulated by the PRA:

· accepting deposits

· carrying out contracts of insurance

· investment firms authorised to deal in investments as principal on their own account

204. The wide variety of business conducted in the financial sector has complicated the question of where to set the outer limits of the PRA's regulatory perimeter. For example, the FSA and the Bank of England indicated that they were considering suggesting that the eventual definition of PRA activities be amended to ensure the PRA could "regulate all firms posing potentially significant risks to the financial system because their activities are in substance analogous to deposit-taking".[158] In a later submission the FSA noted that it was important that the PRA's "perimeter is not defined by the concept of deposit taking and insurance" and that the definition of regulatory activities could change in the future as progress was made on defining the broad and varied issue of shadow banking.[159]

205. The PRA should have a role in supervising shadow banking activity. Gillian Tett pointed to a body of opinion that "argues that by focusing so heavily on the Basel rules for banks the FSB is encouraging this flight of activity into the shadow banks". She therefore asserted that "Everything will depend on whether the FPC and PRA not merely monitor the shadow banking world but are enabled to step in and impose some form of control on that."[160]

206. Most shadow banking takes place in investment firms of one type or another. It is envisaged that, at least initially, the PRA will be given the power to supervise investment firms authorised to deal in investments as principal on their own account but the PRA will develop additional criteria for designation. These criteria are likely to include: the size of a firm; the substitutability of its services; the complexity of its activities; and its interconnectedness with the financial system and any PRA-supervised companies within its group.[161] The definition of investment firms "authorised to deal in investments as principal on their own account" together with the additional criteria the PRA will apply means that only investment firms likely to pose sufficient risk to the stability of the financial system will be inside the PRA's regulatory perimeter. The Bank has stated that it is envisaged that this will be a very small number.[162] There will be significant areas of shadow banking activity that will not be supervised by the PRA under current proposals.

207. The detailed definition of investment firms subject to PRA supervision is likely only to cover the very biggest investment firms operating in the UK. We understand that it is unlikely to encompass firms the significance of the UK arm of MF Global, the US futures broker that has very recently gone into administration. This cannot be right. The collapse of MF Global could affect the stability of the wholesale markets and this is just the type of firm with the PRA should be supervising. The Former Chief Executive of MF Global told a US Congressional committee that he simply did not know where $1.2billion of customers' money had gone. Such firms have tentacles across the system and should not be left to the FCA to regulate. A group of small firms can be 'systemic as a herd' of which the most obvious example in the recent crisis was the US money market industry.

208. There is a strong case for suggesting that any firm that engages in "rehypothecation" of client money and assets should be subject to PRA supervision. Rehypothecation involves a commercial agreement between a firm and client that assets and monies the firm holds in trust for the client can be "on lent" or used in other ways by the firm in its investment activities. The practice can be repeated many times, creating complex webs of counterparty links. MF Global engaged in rehypothecation and this was a significant issue in the Lehman's case. Rehypothecation can pose similar systemic risks to deposit taking.

209. The PRA's regulatory perimeter should be broader. We would expect firms of the significance of MF Global, and firms engaging in rehypothecation of client money and assets, to be supervised by the PRA.

210. Paul Tucker and Hector Sants called for a more comprehensive regime for the PRA's powers in relation to the regulation of holding companies for UK banks and insurers.[163] They noted that the Financial Services and Markets Act gives the FSA only indirect powers over unregulated holding companies of banks, restricted to approving changes of control and limitations on intra-group exposures, and that this meant "supervision of groups headed by an unregulated parent is less effective than for those headed by a regulated firm". They argued that the current restrictions on the regulator's powers were only partially improved by the provisions of the draft Bill,[164]and that in consequence:

165

211. We are persuaded that there is cause for concern in the area of regulation of holding companies, and recommend that the Treasury examine how it can provide the PRA with more comprehensive powers to ensure a consistent regulatory approach.

212. Each financial crisis is different from that which preceded it and it is difficult to anticipate where a crisis could arise.[166] In consequence, it is vital that the new regulatory structure starts with a broad regulatory perimeter and is nimble enough to be able to identify areas of new risk and then extend its reach to police them as necessary.

213. It is right that the designation of PRA regulated activities is left to secondary legislation. The financial landscape develops quickly and any definition fixed in primary legislation could soon become redundant or inadequate. The secondary legislation approach will allow a quicker response if the regulatory perimeter needs to be changed in order to accommodate a new area of risk. Nevertheless, given that the initial designation of PRA regulated activities is a key factor in understanding the intentions and scope of the Bill, a draft of the Order must be available when the Bill is introduced into parliament.

214. The initial order designating PRA-regulated activities, as well as subsequent orders which bring an activity within PRA regulation or move it out of PRA regulation, will be subject to the 28-day affirmative procedure, meaning that the order will be made before it is laid before Parliament and will cease to have effect unless it is approved by both Houses of Parliament within a set period.[167] The House of Lords Delegated Powers and Regulatory Reform Committee noted that "it is usual nowadays for the 28-day affirmative procedure to apply only where there is urgency". It suggested there is a case for amending the Bill to provide for draft affirmative procedure (whereby the order is not made until it has been approved by both Houses) in these cases.[168] We think there is a case to go further than this. The designation of PRA activities is complex and important and needs careful scrutiny. There should be an enhanced form of scrutiny of these orders.

215. Within the last Session there have been two bills containing an enhanced affirmative procedure allowing greater scrutiny of secondary legislation: the Localism Act and the Public Bodies Act. These provide useful examples of how the draft Bill could be amended to ensure enhanced scrutiny of orders designating PRA regulated activities.

216. Section 11 of the Public Bodies Act provides that the Minister may lay a draft order and accompanying Explanatory Memorandum before Parliament. The Act sets out the information that the Explanatory Memorandum must present. From the day on which the draft order is laid, a 30-day period starts ticking. Within this period, the Act provides that either House may decide that an enhanced affirmative procedure should apply to the draft order. This can be triggered in one of two ways: by resolution of either House, or on the recommendation of a committee of either House charged with reporting on the draft order. If the 30-day period lapses without either House or a Committee triggering the application of an enhanced affirmative procedure, then the draft order may be approved by a resolution of each House once a further 10 days have elapsed (creating a 40-day scrutiny period in total). If however the enhanced affirmative procedure is triggered, then a further 30-day period must be allowed to lapse (creating a 60-day scrutiny period in total). The Act provides that where the enhanced affirmative procedure has been applied, the Minister "must have regard to (a) any representations, (b) any resolution of either House of Parliament, and (c) any recommendations of a committee of either House of Parliament charged with reporting on the draft order, made during the 60-day period". Once the 60-day period has lapsed, the draft order may be approved by a resolution of each House of Parliament, or, if the Minister wishes to make material changes to the order, a revised draft order and accompanying statement summarising the changes proposed may be laid before Parliament. No further scrutiny period applies before the revised draft order may be approved by a resolution of each House but any material changes to the draft are subject to scrutiny.

217. The procedures for orders designating PRA activities should be amended to provide for an enhanced affirmative procedure in non-urgent cases, retaining the made affirmative procedure for urgent cases only. We appreciate that there will be instances where fast action is required, but it is not appropriate for the 28-day procedure to be applied as a matter of routine. The enhanced affirmative procedure should be modelled on that contained in Section 11 of the Public Bodies Act.

RESPONSIBILITY FOR CONSIDERING THE ETHICS AND REMUNERATION STRUCTURES OF FIRMS

218. One factor behind banks taking on huge amounts of risk in the run-up to the crisis was the link between management remuneration and returns on equity. This created incentives to keep capital low—which meant banks had less capital to absorb losses when trouble struck—and boost profits through excessive leverage. Sir Mervyn King told the House of Commons Treasury Committee: "I think that the incentives that have been created by linking compensation to the rate of return on equity is clearly a distortion because it gives an incentive built in to raise leverage ... I have never understood why people thought it was a sensible idea to base compensation in these institutions on the return on equity."[169]

219. Robert Jenkins, a member of the interim FPC, said: "Over the last 10 to 15 years it [return on equity] has helped to make many bankers rich and loyal shareholders poor. Moreover it prompts banks to fight to keep loss absorbing capital low. This makes their enterprises vulnerable and our financial system fragile."[170]

220. After the financial crisis erupted the Financial Services Authority introduced a Remuneration Code for senior staff at financial institutions. A revised version came into force earlier this year. The regulatory structure outlined in the draft Bill will not change the Remuneration Code and enforcement will largely be undertaken by the PRA who "will be responsible for ensuring that the remuneration policies ... are aligned with effective risk management and that they do not provide incentives for excessive risk-taking".[171] The FCA will also enforce the Remuneration Code with firms covered by the Code but not regulated by the PRA.

221. Among the Remuneration Code's measures, at least half of variable remuneration should consist of shares rather than cash. The shares awarded in pay packets have to be retained for specified periods. Andrew Proctor, Global Head of Government and Regulatory Affairs at Deutsche Bank, said: "The balance between cash and stock for bonuses has significantly changed in favour of stock ... The deferral periods are now extended out to about five years, typically. The claw-back provisions are much tougher than they have ever been before, either for malice or misconduct or because the profits upon which the bonus decision was made turn out to be illusory. Finally, there is a far greater emphasis on indicators of good and bad behaviour being reflected directly in the bonus decision."[172]

222. In certain cases, supervisors can demand individual contracts be redrafted if they create incentives to excessive risk-taking. Sally Dewar, formerly of the FSA and Managing Director for International Regulatory Risk at JP Morgan, said: "The regulator has the authority to rip up a contract."[173]

223. Other factors could also help prevent bankers and traders building-up excessive risks that occurred in the run-up to the financial crisis. Shareholders of banks and other financial institutions should play a more active role in monitoring directors and senior employees' remuneration schemes to ensure they do not encourage excessive risk-taking. In its recent report on the failure of RBS the FSA suggested that the remuneration arrangements of executives and non-executive directors might be changed so that a significant proportion of remuneration is deferred and forfeited in the event of failure. Regulations of this form have already been introduced for executive directors: they could be strengthened by increasing both the proportion of pay deferred and the period of deferral.[174]

224. The three investment banks who spoke to us—Deutsche, Goldman Sachs and JP Morgan—all stressed the importance of ethical codes at their organisations which could help discourage staff from activities that lead to excessive risk-taking. However, Mr Proctor of Deutsche admitted ethical codes may not have been clearly expressed in the past: "The articulation of them has become clearer. I would think that at bottom they have not changed, but there is a much clearer articulation and expression of them."[175]

225. Supervisors, banks and shareholders must ensure that senior staff remuneration schemes do not lead financial institutions to take on excessive risk. The PRA and FCA should take an active interest in this area and should rigorously enforce the remuneration code. The Government should consider the FSA's recommendations on changing the remuneration arrangements for executives and non-executive directors, or introducing a concept of 'strict liability' of executives and Board members for the adverse consequences of poor decisions, in order to ensure that bank executives and Boards strike a different balance between risk and return. Amendments could be brought forward to this Bill.

RESPONSIBILITY FOR MARKETS

226. Under the current proposals, the FCA will have a role in markets regulation, under its objective to protect and enhance the integrity of the UK financial system. In pursuing this objective, the FCA will be concerned with the soundness and resilience of the trading infrastructure; the integrity of the financial markets, including the reliability of their price formation process; combating market abuse; and addressing the extent to which the UK financial system may be used for the purposes of financial crime.[176]

227. More specifically, the FCA will be responsible for the conduct and prudential regulation of recognised investment exchanges (RIEs)[177]. However, the Bank of England will regulate settlement systems and clearing houses[178].

228. The FSA is particularly concerned about the need for the FCA to be involved in regulation of settlement systems and clearing houses, which will be within the Bank of England's remit:

179

229. The FSA acknowledged "the argument that co-ordination between the PRA and the FCA would be simplified if the PRA (rather than the BoE itself) was also responsible for the prudential oversight of clearing and settlement organisations. We recognise, however, that this would require a further reorganisation of the current BoE structure and thus is probably not justified at this stage. However, in our view there would be merit in ensuring that the legislation is sufficiently flexible to allow for such a change in future, without the need for primary legislation."[180]

230. Market infrastructure—exchanges, listing authorities, clearing houses, and settlement institutions—are central to competition in securities markets. If the FCA is to have a central role on competition, then it will have a significant role in the regulation of financial markets. At the same time the Bank and PRA will have a critical role in terms of clearing, payments and settlement (with regard to prudential systemic risk). It will therefore be important to ensure good coordination mechanisms.

231. For consistency of regulation, there is a strong rationale for keeping regulation of market infrastructure together. Given the PRA's role in regulating prudentially significant firms, we recommend that the regulation of market infrastructure should sit within the PRA. As is the case for other PRA-regulated firms, the FCA will have an important role in regulating market infrastructure with respect to conduct issues, and it is important that the legislation makes this clear. Appropriate coordination mechanisms between the two regulators will be required.

232. There is a gap in resolution arrangements for market infrastructure firms.[181] These are not covered by the provision of the Banking Act 2009. Professor Black, The London School of Economics and Political Science said that "resolution powers should be extended to cope with the failure of a CMI [critical market infrastructure] institution".[182]

233. We are concerned by the gap in resolution arrangements for market infrastructure firms that may be of systemic importance. The Treasury should take action to ensure that this gap is closed.

INFORMATION FROM AUDITORS

234. The PRA and FCA will have a power to require firms to provide information and data in specific forms. It is however important to consider whether other bodies should have a duty to bring certain types of information to the attention of the regulators. Legislation already affords legal protection to auditors who provide confidential opinions on banking clients to supervisors in the interests of better supervision.[183] The practice of regular meetings between auditors and supervisors of banks fell into disuse prior to the banking crisis. In 2006 there was not a single meeting between the FSA and the external auditors of either Northern Rock (PwC) or HBoS (KPMG), and only one meeting between the auditor of RBS (Deloitte) and the FSA. In 2007 there was only one FSA/auditors meeting with each bank auditor. All three banks were bailed out by the taxpayer. The FSA told the House of Lords Economic Affairs Committee: "The regular practice of auditor-supervisor meetings fell away gradually following the transition from the Bank of England to the FSA as banking supervisor."[184]

235. The House of Lords Economic Affairs Committee earlier this year suggested a statutory obligation for bank auditors and supervisors to set up an effective working relationship. That Committee suggested that this could take the form of a "mandatory quarterly meeting, at the highest appropriate level, between the supervisory authority and the external auditor of each bank whose failure might, in the view of the supervisory authority, pose a systemic risk. There might be a further requirement for either side to initiate a meeting between the regular quarterly meetings should information come to light which might warrant such a meeting".[185]

236. The PRA will be better able to identify risks building up in individual firms if it established an effective working relationship with bank auditors. The draft Bill should be amended to place a statutory duty on the PRA to meet regularly with bank auditors. The Treasury should consider whether any complementary duties can and should be placed on auditors for example to draw certain risks to the attention of regulators.

Quality of information held by firms

237. It is important to ensure that firms collect, hold and analyse information in a way that allows them and the regulator to understand the risks they are exposed to. This was not happening in the run up to the 2007 crisis. Intellect, a trade body for UK technology industry, made this point:

"Banks failed to collate and interpret risk data of suitable quality so that they could identify the risk that they were holding across their disparate operations.

186

238. It is worrying to consider that under data reporting rules regulators may end up with a mass of data that they do not have the ability to interpret. The current FSA rule book has a whole section dedicated to reporting requirements and moves in the EU to agree a common reporting directive are likely to increase the information to be reported on a regular basis. Sir Mervyn King suggested that "Rather than burdening the banks with a massive data reporting requirement, we should make it clear to them, "We think you ought to know the answers to the following questions, and from time to time we will want to know the data, too, but do not send it to us until we ask for it."[187]To an extent this already happens. Andrew Bailey added "From time to time we do it now. I do it in running supervision. We say, "We want this by close of business tomorrow." Sometimes I get protests from chief executives of banks and I say to them, "Look, I'm not asking you for anything you should not have yourself to run your business."'[188]

239. Whether or not the regulators rely on regular reporting or more ad hoc requests for information they need to be sure that financial firms themselves have robust standards for recording information. Poor quality information about exposures and counterparties directly contributes to systemic risk. Intellect suggested that "Banks need to undertake significant internal changes to reform their ability to collate accurate risk data, and to improve access for regulators to it so that they can adequately perform their supervisory and financial stability objectives". Improved information standards will not only help auditors, they will allow company boards to make better decisions.

240. The USA has led the way on this issue. The Dodd-Frank Act created the Office for Financial Research which was given responsibility for monitoring of systemic financial risks and, in order to undertake this task, has been given powers for the setting of data standards for the industry. In order to allow effective monitoring of systemic financial risk, the Dodd-Frank Act also requires that OTC derivative contracts are recorded in trade repositories, a step that requires standardisation of reporting across the industry.

241. Gillian Tett told us that the Office for Financial Research is an important step because it would "force banks to have a much more proactive and timely system of reporting activity ... In an ideal world I would be putting money into trying to create some kind of international system for reporting bank positions and capital flows".[189]

242. Improved industry-wide standards for the recording of data could help achieve stability of the UK financial system. Amongst other advantages it would allow the Regulators to shift away from the routine collection and processing of regulatory returns, information which may be little relevance to financial stability, and instead request more limited and more relevant data when the need arises.[190]

243. The Bill should be amended to place a duty on the Bank of England (or its subsidiary the PRA) to develop information standards for the UK financial services industry and to report regularly on progress in improving these information standards in order to support financial stability.

Powers and responsibilities of the FCA

RESPONSIBILITY FOR CONSUMER CREDIT

244. The OFT currently has responsibility for regulating consumer credit under the Consumer Credit Act. As part of this, the OFT is the licensing authority and main enforcement body for regulated consumer credit (including personal loans, credit card lending and the provision of goods and services on credit as well as related activities such as debt collection and debt management).

245. The Government has consulted on transferring responsibility for consumer credit from the OFT to the FCA, but has not yet announced its final decision.[191] In the consultation, the Government set out its preference to transfer consumer credit to the FCA within a regime based on the Financial Services and Markets Act.

246. Consumer groups have supported the transfer to the FCA, on the grounds of increased clarity for consumers. Martin Lewis told us "the fact that a bank account is regulated by the FSA when in credit but probably by the OFT when it is overdrawn because it is consumer credit is just nonsense."[192] However, opinion is divided as to whether if this transfer takes place consumer credit should be covered by the Consumer Credit Act, or re-written to fit with the Financial Services and Markets Act.

247. The Consumer Credit Association is very concerned by the potential transfer of responsibility to the FCA, because it believes that such a move would "very significantly increase the regulatory cost/load of running a credit business in the UK (probably by at least a factor of five)". This is based on the fact that "the two regimes (FSA and OFT) operate at quite different cost levels. FSA spends c. £500 million per year to regulate c.25,000 firms. OFT spends c.£20m-£30m per year supervising c.96,000 traders."[193]

248. The Consumer Credit Association also believes that unsecured credit is different from products such as insurance and mortgages. It said that for unsecured credit, the risks to consumers and the complexity of the products is low.[194] Other industry bodies such as the BBA also took the view that care will be required given that considerations for Consumer Credit Act regulated lending must be different to that for savings, insurance and mortgages.[195]

249. There are however strong arguments for transferring consumer credit to the FCA, which will have a brief to protect consumers. The FCA's responsibilities for authorising firms would allow it to consider carefully the business model of firms planning to offer consumer credit and consider at a very early stage whether that model is likely to cause detriment to consumers. The FCA will have important new powers to ban products that do not meet minimum standards or should not be sold to certain categories of consumers (see next section).

250. We welcome the Government's decision to look at whether consumer credit should be moved to the FCA. Consumer credit products may pose different problems to other financial products, and it is important that the way in which they are regulated is proportionate, taking into account costs to firms and potential benefits to consumers. However, given the potential for consumer detriment in the case of some types of credit products, there are significant benefits in transferring consumer credit to the FCA, to ensure clarity of responsibilities, and to ensure that the FCA is better able to identify and deal with consumer issues across the financial services market.

RESPONSIBILITY FOR PENSIONS

251. Pension regulation is split between the FSA, which supervises personal pensions, and the Pensions Regulator which focuses on occupational pension schemes.

In written evidence, Martin Wheatley, Chief Executive-designate of the FCA, explained the FCA's role under the new regime;

196

CONSUMER PROTECTION POWERS

252. In the wake of previous scandals, such as payment protection insurance, it is clear that improvements need to be made in the area of consumer protection. The FCA will have three main new powers, not previously available to the FSA, in the area of conduct regulation:

Early publication of disciplinary action

197

Financial promotions power

198

Product intervention power

199

253. These are powerful new tools. There is concern among some sectors of industry that some of the new powers unfairly disadvantage them.

EARLY PUBLICATION OF DISCIPLINARY ACTION

254. Early publication of disciplinary action is common practice amongst regulators of other sectors. Consumer Focus said that:

200

201

255. Nevertheless the industry argues that this power could cause reputational damage to firms that are subsequently found not to be in breach of rules. AXA said that the power was "contrary to … the principle that an individual is innocent until proven guilty".[202]

256. The Government said that it has taken these concerns into account in designing the power. In particular it has proposed a series of safeguards:[203]

· The regulator will have the opportunity to consider the case for publication on a case-by-case basis, rather than being required to publish;

· The regulator must consult the person to whom the notice is given before making any disclosure;

· The FCA may not publish if in its opinion, it would be unfair to the person against whom action is being taken, if it would be prejudicial to the interests of consumers, or if it would be detrimental to financial stability.[204]

257. These safeguards may significantly reduce the effectiveness of the power to publish early warnings of disciplinary action. The FSA considers that the requirement to consult "will seriously undermine the effectiveness of this power" to the point that it is likely to be of little use. It is concerned that most individuals and firms will object to warning notices, resulting in "satellite litigation" with firms and individuals seeking injunctions through the courts to restrain the authorities from making matters public.[205]

258. Given the powers of regulators in other sectors, and indeed, the process in criminal and civil proceedings, we see no reason why financial services firms should be granted greater dispensation from public disclosure. Requiring the FCA to consult could seriously undermine the effectiveness of this new power. The fact that the FCA will not be publishing the warning notice itself, but only the fact that it has issued one, and the fact that it will need to take into account a number of considerations in deciding what to publish should provide sufficient safeguards. We recommend that the requirement to consult before disclosing the fact that a warning notice has been issued should be removed from the draft Bill. However, we do think it important that the FCA has the discretion to weigh the relevant factors and decide which set of interests listed in the Bill (fairness, potential to be prejudicial and potential for detriment to financial stability) are best served by disclosing or not disclosing that a warning notice has been issued. We also think that the FCA should be required to publish guidance as to how it will exercise its discretion in respect of disclosing that a warning notice has been issued. This will provide some degree of certainty to firms over how the FCA will treat different cases.

TRUSTED CONSUMER PRODUCTS

259. Complex products combined with a lack of financial literacy is a significant problem in financial markets. In para 126, we recommended that the FCA should have regard to the needs that consumers may have for advice and information that is timely, accurate, intelligible to them and appropriately presented. If the FCA is diligent about this duty then it should make progress in helping consumers understand the products they are buying. There is however more that could be done.

260. Consumer Focus proposed a Trusted Products Board[206] to "set common standards for a suite of mass market financial services consumer products". Consumer Focus suggested that the Board could be funded by the financial services industry. It could have active industry participation but an independent Chairman and board. Its objective would be to agree:

· A suite of mass market consumer products which would be defined by a set of common minimum standards—of design, governance and management

· The specific common standards for each identified product

· Common terms to describe products and define what is included in the product price, so products could be compared and consumers could shop around and compare like with like

· A logo or kitemark which providers of qualifying products could license and use for products which met the agreed minimum standards

· To monitor the market and identify and ban any emerging additional product features on products which otherwise met minimum standards if the Trusted Products Board considered they could cause consumer detriment

· To keep under review changing consumer needs and the changing financial services environment and (a) add new products to the suite of trusted products as required and (b) modify or remove items from the suite of existing approved products

261. A system along these lines, that would help retail consumers easily identify simple low-cost financial products, could have significant benefits. Stakeholder Pensions provide something of a precedent. It could make it easier for consumers to compare products and increase the incentives on firms to deliver value for money. It would also be necessary to indicate categories of people for whom these products would and would not be suitable.

262. However, it would not be right for the regulator to undertake itself or authorise others to select and endorse specific products or types of products. To do so would raise all sorts of issues of legal liability in the event that such products failed or were mis-sold or mis-bought. The FCA could certainly not brand some products as "trustworthy" while still authorising firms to market products refused that label.

263. A system of identifying and certifying simple, low cost financial products is an attractive idea. This is not a role that the regulator should take on but it is something the voluntary sector itself may be well placed to do. The FCA should be prepared to help the voluntary sector in these endeavours by providing information on products and their costs. We welcome the Government's announcement that a new steering group made up of Government, industry, trade and consumer body representatives has been set up to consider hot to bring simple products to market and to report back to the Treasury.[207]

COMPETITION POWERS

264. Having considered the role of competition in the FCA's objectives at para 99, it is necessary to consider the division of responsibilities and powers between the OFT and the FCA.

265. In the UK, the OFT is the main competition authority. Its responsibilities include:

· applying and enforcing competition law, for example, on anti-competitive agreements and abuse of a dominant position.

· conducting "first phase" markets investigations, which involves looking at whether market features prevent, restrict or distort competition. If the OFT has reasonable grounds to suspect that this is the case, it can make a market investigation reference to the Competition Commission (CC).[208] If the CC finds that there are adverse effects on competition, it can impose remedies.

· conducting "first phase" investigations to determine whether a merger results or may be expected to result in a substantial lessening of competition. If the OFT finds that this is the case, it must refer the merger to the CC, which conducts the "second phase" of the investigation, and if required, imposes remedies.

· investigating super-complaints. Designated consumer bodies can make super-complaints to the OFT in situations where a feature, or combination of features, of a market appears to be significantly harming the interests of consumers. The OFT has a duty to respond to a super-complaint within 90 days.

266. In some regulated sectors, (such as telecoms, water, aviation, energy), the sector regulator has concurrent powers with the OFT. This means they have powers alongside the OFT to apply and enforce competition law[209], and can refer markets directly to the Competition Commission.[210] They can also investigate super-complaints. They do not however have a role in merger investigations, which are the responsibility of the OFT and Competition Commission.

267. Under the proposals in the draft Bill, the OFT will remain the lead regulator on competition issues in financial markets, with responsibilities for making market investigation references to the Competition Commission, and for applying and enforcing competition law. The FCA will have the power to make an "enhanced referral" to the OFT[211] where it has identified a possible competition issue that may benefit from technical competition expertise or require recourse to powers under competition law. Specifically, the draft Bill states that:

212

268. The OFT will have a statutory duty to respond to a referral within 90 days. The OFT would also be able to carry out competition scrutiny of the PRA and FCA.[213]

269. The Government has decided not to give the FCA concurrent competition powers as "it did not consider that these delivered the desired outcomes."[214] It also summarised views given in response to its consultation:

215

270. The FSA expressed the concern that the current proposals may create an overlap in responsibilities between the OFT and FCA. It wants the FCA to have the following powers and functions alongside its proposed operational objective to promote effective competition for the benefit of consumers:

· An explicit function to keep financial services markets under review.

· A function/power, for the FCA, instead of the OFT, to refer financial services markets directly to the Competition Commission, for investigation, where it suspects market features are preventing, restricting or distorting competition. This is known as a 'Market Investigation Reference power'. This should also allow the FCA to agree certain undertakings—e.g. including divestment—with firms in lieu of a reference.

· Consumer organisations should be able to make super-complaints to the FCA rather than the OFT on aspects of the operation of financial services markets which are harming consumers."[216]

271. The FSA argued that had it had these powers it would have better been able to deal with issues such as payment protection insurance.[217] Consumer groups have also argued that the FCA should be able to investigate super-complaints.[218]

272. The FSA's proposal differs from that of other sector regulators in two ways. First, other sector regulators have concurrent powers alongside the OFT, rather than powers to the exclusion of the OFT. Secondly, other sector regulators have Competition Act powers alongside the OFT; the FSA does not want Competition Act powers (which would allow it to look at anti-competitive agreements and abuse of a dominant position), as "the OFT already possesses both legal and economic expertise in this area and is, therefore, best placed to carry out this function."[219]

273. There are concerns about any strengthening of the FCA's competition objectives because of the potential duplication with the OFT, as well as the lack of competition expertise in the FCA. Set against this, the FCA will have strong expertise in financial markets, which will make it well-placed to identify potential competition issues, and their impact on the market. For example, account number portability, which the ICB said should be re-evaluated as an option in the future, has implications for the technical data systems used by industry, which the FCA would be well-placed to investigate. This makes it desirable for the FCA to have an objective that explicitly focuses on competition, as well as powers that allow it to achieve this objective. It could be argued that it would be difficult for the FCA to achieve objectives of promoting competition with its powers limited to OFT referrals. If the FCA were to take on further competition powers, it would need to increase its competition expertise in terms of staffing, and the relationship with the competition authorities will need to be carefully considered.

274. The OFT does not think that the FCA should have a formal concurrent power to make market investigation references to the OFT for the following reasons:

· "The risks of inconsistent use of these tools across the competition regime which lead to greater uncertainty for business, and the likelihood of financial business pressing for 'special treatment' within the competition regime;

· The need for the FCA to develop a skillset that the FSA currently does not possess around competition assessments—and the parallel risk of then creating a duplicative set of skills in different public authorities;

· The fragmentation of roles weakening the ability of the competition regime to support the Government in tackling strong vested interests and the usual problems of overlaps, or, more likely, gaps in action;

· The risk, as with other sector regulators, that the tool is used by neither the FCA nor the OFT; and

· Partly as a result of these, the likely withdrawal by the OFT from working on the markets covered by the FCA leaving the 'sectoral' body to conduct these activities. We see this risk as especially important. One specific consequence of this would be that external assessment of the impact of the FCA's own rules on competition—despite their potential significance themselves as a barrier to entry, for example would be diminished. In short would the FCA ever be capable of carrying out thorough independent analysis of its own rulebook from a competition perspective as part of a market study?"[220]

275. The OFT's concerns apply to the option of giving the FCA concurrent powers, rather than the FSA's preference for powers to be taken away from the OFT and given to the FCA. However, to a greater or lesser extent, some of these concerns will also be relevant to the FSA's preferred option. For example, the withdrawal of the OFT from working on financial markets and consequent lack of independent competition scrutiny of the FCA's rules is clearly a greater risk if the OFT's powers in this area are taken away altogether.

276. Competition expertise is also important in building a case. The OFT does have significant experience in investigating competition issues in financial markets. In recent years, it has conducted reviews on personal current accounts, barriers to entry, expansion and exit in retail banking, payment protection insurance (following a super-complaint), and the HBOS and Lloyds merger (prior to the acquisition). However, the competition regime in financial services markets has arguably not delivered significant improvements in recent years. The ICB report concluded that "most of the competition problems highlighted in 2000 by the Cruickshank report into competition in UK banking remain".[221]

277. The Government has recently consulted on changes to the UK competition regime. The consultation includes a proposal to merge the competition functions of the OFT and Competition Commission to create a Competition and Markets Authority (CMA), The outcome of this consultation will affect how the future FCA may interact with the competition authorities.

278. In commenting on the consultation, the OFT highlighted that there were concerns that sector regulators have not made sufficient use of competition powers, and that it may be undesirable to further fragment UK competition powers:

222

279. The Government should review its decision on the FCA's competition powers. The FCA should be given concurrent powers alongside the OFT to make market investigation references to the CC. The FCA will need greater competition powers to achieve its recommended objective than is currently set out in the draft Bill.

280. We note that the Government is consulting on a proposal for a "clear, transparent and fair process, led by the regulator, for dealing with situations where conduct risks have crystallised and are causing mass consumer detriment." However, whereas the proposed process focuses on "mass consumer detriment", triggering a super-complaint is based on the lower threshold of situations "where a feature, or combination of features, of a market appears to be significantly harming the interests of consumers". We therefore do not think that the proposed process for mass detriment cases on its own provides a sufficient avenue for consumer issues to be brought to the attention of the FCA. We also recommend that designated consumer bodies should be able to make super-complaints to the FCA, as well as the OFT.

281. It is appropriate for the FCA to have concurrent powers in this area, as in some situations, the OFT may be best-placed to investigate super-complaints and conduct market studies, for example, where the issues involve cross-market problems that may not all fall within the FCA's remit (particularly consumer credit) or if the issue relates to effects on competition of rules imposed by the FCA itself, for example, as part of its prudential regulation responsibilities.

282. The OFT may also be better placed to take in lead in cases where it is unclear whether the right solution will be a market investigation reference to the CC or action under the Competition Act. The FCA would not have action under the Competition Act as an option as it would not have powers in this area.

283. If this recommendation is accepted, there will be a need for coordination between the FCA and the competition authorities, as well as a need for the FCA to increase its access to competition expertise. Proposals such as tasking the new CMA with acting as a central resource for sector regulators on competition issues, considered as part of the Government consultation on reforming the competition regime, may be of benefit in aiding coordination and ensuring that the FCA has access to competition expertise.

PRA and FCA duty to co-ordinate

284. The draft Bill places a duty on the PRA and the FCA to ensure co-ordinated exercise of specific functions.[223] It also requires them to prepare and maintain a Memorandum of Understanding which describes how they intend to comply with the duty. The MOU will be subject to annual review and the draft Bill requires the PRA and the FCA to include in their annual reports an account of how they have coordinated during the year.[224] When considering matters of common regulatory interest both regulators must consider the first two regulatory principles to which they are both subject. These are:

(a) the need to use the resources of each regulator in the most efficient and economic way;

(b) the principle that a burden or restriction which is imposed on a person should be proportionate to the benefits what are expected to result.

285. It is expected that there will be around 1700 dual-regulated firms and there is concern amongst those firms that dual-regulation will be a considerable burden. The Association of British Insurers stated that close co-ordination between the PRA and FCA will be key to ensuring that the new structure operates effectively.[225] AEGON highlighted industry concern that the authorisation and approvals for dual-regulated firms may prove unnecessarily burdensome.[226] Suggestions to reduce the burden on dual-regulated firms included developing shared services and a single point of contact for handling tasks such as authorisation of firms and individuals; variations of permissions; collection of all fees and levies etc. The Building Societies Association, Association of British Credit Unions and the Institute of Financial Planning all supported a single point of contact as necessary for small firms to negotiate the regulatory system.[227] Another suggestion was that there should be a single rule book for dual regulated firms.

286. Martin Wheatley said that while the two regulators would work to minimise the burden on dual-regulated firms in terms of information reporting it was inevitable that two separate regulators would have two separate rule books and two separate systems for making contact:

228

287. He did however provide assurance that the two regulators would share information:

229

288. Hector Sants stated that:

"The FSA is currently considering with the Bank of England how best to develop and set out those regulatory provisions which will apply to dual-regulated firms. An interim solution agreed between the FSA and the Bank is to carry over the FSA's existing rulebook past the regulatory cutover period and to badge each provision in the Handbook so that firms can readily identify which provisions will be the responsibility of the PRA and which that of the FCA. Thereafter, the PRA and the FCA will jointly consider how best to present the provisions for which they are separately responsible."

289. It is important that firms regulated by both the PRA and FCA are not subject to considerably higher costs or considerably more bureaucracy.

290. The Treasury's position is that it should be for the regulators themselves to develop plans for operational coordination and for parliament to hold them to account for doing so effectively. To prescribe methods of co-ordination in legislation "would be inflexible and unnecessarily prescriptive, removing from the framework the capacity for regulators to learn, develop and improve".[230]

291. The PRA and FCA must co-ordinate as far as possible to minimise the burden on dual-regulated firms. We welcome the assurances that information given to one regulator will be shared with the other so that the same information will not have to be given twice. While a joint rule book and a single point of contact may not be possible, the two bodies should consider other methods of reducing the burden. A draft of the Memorandum of Understanding on co-ordination between the PRA and FCA must be available when the Bill is introduced into parliament.

292. For some specific functions, such as authorisations, the PRA will lead but will seek the consent of the FCA. However, the draft Bill provides that the PRA alone is responsible for approving individuals performing significant influence functions in dual-regulated firms. It is expected that the PRA would consult the FCA under the general duty to consult. The FSA expressed concern that the PRA will have to consult the FCA but not seek its consent for approved persons:

231

293. The future senior management of the FCA therefore feel strongly that the draft Bill should—in line with the arrangements for authorisation of firms—require the FCA's consent to the approval by the PRA of any persons holding significant influence in a dual-regulated firm.[232] We have considerable sympathy with this argument. If the FCA is to be able to effectively regulate the conduct of firms it must have a say over whether the people running those firms are fit and proper.

294. The draft Bill should be amended so that the FCA will have to give its consent before the PRA approves any persons holding significant influence in a dual-regulated firm.

Influencing EU and international decisions

295. The Treasury, the Bank, the PRA and the FCA will each have separate responsibilities for representing UK interests abroad. The Treasury will continue to represent UK interests in G20, G7 and other international forums. The Bank of England is represented on several G20 and G7 bodies, including the Financial Stability Board. The PRA and FCA will have different responsibilities for representing the UK on the new European Supervisory Authorities (see para 298 below).

296. Given the importance of financial services to the UK economy, it is important that the UK plays a leading role in these organisations. There is however a risk that the UK does not speak with one voice on the international stage and that one body has to represent the UK's position on a subject where it is not the competent national expert. These risks are particularly apparent when considering how the UK regulatory structure will map onto the European regulatory structure.

297. At the top of the new European framework is the European Systemic Risk Board (ESRB). This is a new body that is responsible for macro-prudential oversight of the EU financial system. It will assess, and propose recommendations to reduce, systemic risks in the financial sector. Its remit is therefore very similar to the FPC although it will only have an advisory capacity. Below the ESRB is a system of European financial supervisors, consisting of three European Supervisory Authorities (ESAs). The ESAs are tasked with: harmonising and coordinating the work of Member States' national regulatory bodies; drafting and implementing technical regulatory standards; and mediating between national supervisors where conflicts arise.

298. The ESAs' regulatory responsibilities are divided along subject areas (banks, insurance and securities), while the new UK regulatory bodies will instead be split into prudential and conduct regulation across all subject areas. The two structures are therefore quite different. This difference means it is not simple to ensure that the right people represent the UK on each of the ESAs. Each Member State has one voting seat on each ESA. The draft Bill provides that the PRA will hold the UK's voting seat on the European Banking Authority and European Insurance and Occupational Pensions Authority. The FCA will represent the UK's interests on European Securities and Markets Authority. There will therefore be substantial areas of the ESAs' work which are not the primary responsibility of the institution that holds the voting seat. When this occurs, effective cooperation between the regulatory authorities will be crucial to ensure that the UK's views are best represented.

299. The difference in structure between the UK and European regulatory authorities is a cause of significant concern for some. Barclays stated that "The proposals seem to largely ignore the evolution of a new EU regulatory regime".[233] Sharon Bowles MEP, Chair of the European Parliament Economic and Monetary Affairs Committee, points out that the FCA will be responsible for only about half of ESMA's remit, "leaving the UK views on substantial and relevant issues essentially unrepresented".[234] However, Andrea Enria told us that he did not envisage any difficulties with the differences in the EU and UK regulatory architectures "We have a lot of different institutional architectures across Europe. There are other countries with a twin-peak type of construction, others which are sectoral and others which are still fully integrated. We need to have a European setting that works together with different national settings".[235]

300. The Government is seeking to ensure that the UK's representation on the international stage is as strong as possible by using the draft Bill to ensure that the relevant bodies co-ordinate. Clause 44 requires the Treasury, the Bank of England, the FCA and the PRA to prepare and maintain an MOU describing how they intend to co-ordinate the exercise of their relevant functions so far as they relate to membership of, or relations with, the European Supervisory Authorities,[236] EU institutions and other international organisations.

301. Subsection (4) requires the MOU to be made with a view to ensuring that:

· the UK authorities agree consistent objectives in relation to matters of common interest

· they exercise their relevant functions in a way that is likely to advance those objectives

· they exercise their relevant functions in a way that is consistent and effective.

302. Subsection (5) requires the MOU to make particular provision on the following points:

· which authorities are members of which international organisations

· which authority will represent the UK at certain international organisations

· what procedures the authorities will follow in agreeing consistent objectives

· how the authorities will consult each other

303. Hector Sants stated that it is "vitally important ... that Government take the lead in focusing on these financial regulation issues and co-ordinate all other bodies to ensure that you are seeking to influence across the whole spectrum of the various arenas and fora where decisions are made. Effective intervention has to be a fully co-ordinated event between Government and individual authorities. There is an argument for ensuring that Government are doing that. Whether the right place for that is in a Bill is a matter for the Government and Parliament".[237]

304. The CBI suggested the establishment of an executive level international coordination committee, directly accountable to Boards of the regulatory bodies and ultimately to the Treasury.[238] This proposal was supported by Nationwide[239] and Fidelity International.[240]

305. We strongly support proposals for an international regulatory committee. To be really useful it would need to go wider than just representatives of the FCA and PRA. We suggest that the international co-ordination Memorandum of Understanding establishes a committee responsible for ensuring the UK authorities agree consistent objectives and exercise their functions in a way that is effective. This committee should report to the Chancellor and include representatives of the PRA, the FCA, the Bank and the Treasury. The Treasury should chair this committee.

107 HM Treasury, A new approach to financial regulation: the blueprint for reform, par 2.42 Back

108 The cases referred to are specified later in the clause and include when the Secretary of State might reasonably be expected to regard it as appropriate to provide financial assistance to a financial institution. Back

109 Clause 42 Back

110 Treasury supplementary written evidence Back

111 House of Commons Treasury Committee, 21st Report (2010-12) Accountability of the Bank of England (HC 874), para 165. Back

112 Ibid, para 166 Back

113 Ibid, para 166 Back

114 Bank of England Act 1946, Clause 4 Back

115 Back from the Brink: 1000 days at No 11, Alistair Darling, Atlantic Books, 2011, pg 57-58 Back

116 Clause 3 (new Bank of England Act 1998 clause 9U) Back

117 Bank of England further supplementary written evidence Back

118 Financial Services and Markets Act, Section 165A Back