Conclusions and recommendations
Chapter 1: Introduction
1. Banks
in the UK have failed in many respects. They have failed taxpayers,
who had to bail out a number of banks including some major institutions,
with a cash outlay peaking at £133 billion, equivalent to
more than £2,000 for every person in the UK. They have failed
many retail customers, with widespread product mis-selling. They
have failed their own shareholders, by delivering poor long-term
returns and destroying shareholder value. They have failed in
their basic function to finance economic growth, with businesses
unable to obtain the loans that they need at an acceptable price.
(Paragraph 1)
2. Banks
have a crucial role in the economy. Banking can make an immense
contribution to the economic well-being of the United Kingdom,
by serving consumers and businesses, and by contributing to the
United Kingdom's position as a leading global financial centre.
The loss of trust in banking has been enormously damaging; there
is now a massive opportunity to reform banking standards to strengthen
the value of banking in the future and to reinforce the UK's dominant
position within the global financial services industry. A reformed
banking industry with higher levels of standards has the potential,
once again, to be a great asset to this country. (Paragraph 6)
3. The
restoration of trust in banking is essential not just for banks.
It is essential to enable the industry better to serve the needs
of the real economy and to contribute effectively to the UK's
role as a global financial centre. (Paragraph 7)
4. The
UK is a global financial centre, but a medium-sized economy. The
benefits of being a global financial centre are very important
in terms of jobs, investment, tax revenue and exports. In finance,
the UK is a world leader. But being a global financial centre
with a medium-sized wider economy also poses risks, as was seen
in the bail-outs and huge injections of taxpayers' money which
took place during the financial crisis. It is essential that the
risks posed by having a large financial centre do not mean that
taxpayers or the wider economy are held to ransom. That is why
it is right for the UK to take measures, some already taken or
in prospect, which not only protect the UK's position as a global
financial sector, but also protect the UK public and economy from
the associated risks. Much of this Report is about how that should
be done. (Paragraph 8)
5. Unless
the implicit taxpayer guarantee is explicitly removed, the task
of improving banking standards and culture will be immeasurably
harder. The principal purpose and effect of the post-banking crisis
measures now being implemented, both the requirements of Basel
III and through the Banking Reform Bill, is to make it less likely
that banks will fail. That is all to the good. But it cannot guarantee
that there will never be a major bank failure. It is important
to make it clear that, should such a failure occur, the bank should
be allowed to fail. That is to say, while both the payments system
and insured depositors will be protected, there should be no bail-out
of a bank. (Paragraph 9)
Chapter 2: The public experience of banks
6. The
interest rate swap scandal has cost small businesses dear. Many
had no concept of the instrument they were being pressured to
buy. This applies to embedded swaps as much as standalone products.
The response by the FSA and FCA has been inadequate. If, as they
claim, the regulators do not have the power to deal with these
abuses, then it is for the Government and Parliament to ensure
that the regulators have the powers they need to enable restitution
to be made for this egregious mis-selling. (Paragraph 19)
7. Major
banks and some senior banking executives remain in denial about
the true extent of PPI mis-selling. Over a significant period
of time they ignored warnings from consumer groups, regulators
and parliamentarians about PPI mis-selling. They used legal challenges
to frustrate and delay the actions of the FSA, the FOS and the
Competition Commission. Rather than upholding high levels of professional
standards, senior executive pursued a box-ticking approach to
compliance, adhering only to the specifics of their interpretation
of the regulator's detailed rules in this area, rather than pursuing
an approach to selling PPI that was truly in keeping with the
spirit of the FSA's requirement that firms have a duty to treat
their customers fairly. The IRHP and PPI mis-selling debacles
both highlight how banks appeared to outsource their responsibility
to the regulator; banks must not be allowed to do to this again
if future scandals are to be avoided; and bank executives must
demonstrate that they have changed significantly their cultural
approach to selling products to customers if trust is to be fully
restored to the sector. (Paragraph 28)
8. An
assessment of what has happened to cause concern about standards
and culture in banking needs to consider the public experience.
The public are customers of the banks. The public as taxpayers
have bailed out the banks. The public have the sense that advantage
has been taken of them, that bankers have received huge rewards,
that some of those rewards have not been properly earned, and
in some cases have been obtained through dishonesty, and that
these huge rewards are excessive, bearing little or no relationship
to the value of the work done. The public are angry that senior
executives have managed to evade responsibility. They want those
at the highest levels of the banks held accountable for the mis-selling
and poor practice. The stain of many scandals has obscured much
of the good work that banks have done, and continue to do, and
the honesty and decency of the vast majority of bank employees.
However, the weakness in standards and culture that has contributed
to the loss of public trust in banks has not been confined to
isolated parts of a few sub-standard banks. It has been more pervasive.
Trust in banking can only be restored when it has been earned,
and it will only have been earned when the deficiencies in banking
standards and culture, and the underlying causes of those deficiencies,
have been addressed. (Paragraph 51)
Chapter 3: The underlying causes
This time is different
9. Banking
history is littered with examples of manipulative conduct driven
by misaligned incentives, of bank failures born of reckless, hubristic
expansion and of unsustainable asset price bubbles cheered on
by a consensus of self-interest or self-delusion. An important
lesson of history is that bankers, regulators and politicians
alike repeatedly fail to learn the lessons of history: this time,
they say, it is different. Had the warnings of past failures been
heeded, this Commission may not have been necessary. (Paragraph
66)
10. A
commission on banking standards cannot address the causes of the
financial cycle which is, in any case, extremely unlikely to be
eradicable. Nor should the recommendations of a UK body be expected
to correct, or attempt to correct, all that is wrong in a global
industry. However, that does not mean that nothing should be done.
A great deal can and should be done to reduce the risk of future
crises and to raise standards. There is currently a widespread
appetite for measures to constrain the misconduct, complacency
and recklessness that characterised the last boom and its aftermath.
However, measures that are implemented while memories are fresh
will be at risk of being weakened once the economic outlook improves,
memories fade, and new, innovative and lucrative approaches to
global finance emerge. (Paragraph 67)
Incentives to be unmanageable
11. Large
banks still benefit from a significant implicit taxpayer guarantee
as a result of their status of being too big to fail and too complex
to resolve. The guarantee affords banks access to cheaper credit
than would otherwise be available and creates incentives for them
to take excessive risks. The guarantee also distorts competition
and raises barriers to entry. Success does not depend simply on
being prudently run or on serving customers effectively, but on
the implicit guarantee. The taxpayer guarantee has a wide range
of harmful effects and underpins many of the failings that we
identify in ensuing sections. (Paragraph 74)
12. The
incentives for banks to become and remain too big and complex
are largely still in place. As well as reinforcing the distorting
effects of the implicit taxpayer guarantee, this makes banks as
currently constituted very difficult to manage. Incentives to
pursue rapid growth have contributed to the adoption by banks
of complex, federal organisational structures insulated against
effective central oversight and strategic control. These incentives
were reinforced as rival banks grew through acquisitions of firms
whose standards and culture they scarcely understood. Many of
the consequences of unchecked pre-crisis expansion and consolidation
remain, as do the perverse incentives that promoted it. As a result,
many banks remain too big and too complex to manage effectively.
(Paragraph 86)
13. Excessive
complexity in the major banks is not restricted to organisational
structure. The fuelling of the financial crisis by misguided risk
models was not simply the consequence of some mathematicians getting
their equations wrong. It was the result of ignorance, coupled
with excessive faith in the application of mathematical precision,
by senior management and by regulators. Many of the elements of
this problem remain. (Paragraph 93)
14. One
of the most dismal features of the banking industry to emerge
from our evidence was the striking limitation on the sense of
personal responsibility and accountability of the leaders within
the industry for the widespread failings and abuses over which
they presided. Ignorance was offered as the main excuse. It was
not always accidental. Those who should have been exercising supervisory
or leadership roles benefited from an accountability firewall
between themselves and individual misconduct, and demonstrated
poor, perhaps deliberately poor, understanding of the front line.
Senior executives were aware that they would not be punished for
what they could not see and promptly donned the blindfolds. Where
they could not claim ignorance, they fell back on the claim that
everyone was party to a decision, so that no individual could
be held squarely to blamethe Murder on the Orient Express
defence. It is imperative that in future senior executives in
banks have an incentive to know what is happening on their watchnot
an incentive to remain ignorant in case the regulator comes calling.
(Paragraph 105)
Paid too much for doing the wrong things
15. Public
anger about high pay in banking should not be dismissed as petty
jealousy or ignorance of the operation of the free market. Rewards
have been paid for failure. They are unjustified. Although the
banks and those who speak for them are keen to present evidence
that bonuses have fallen, fixed pay has risen, offsetting some
of the effect of this fall. The result is that overall levels
of remuneration in banking have largely been maintained. Aggregate
pay levels of senior bankers have also been unjustified. Given
the performance of the banks, these levels of pay have produced
excessive costs. Indeed, at a time of pay restraint in the public
and private sectors, they will raise significant anger amongst
taxpayers who have been required to subsidise these banks. These
elevated levels of remuneration are particularly unacceptable
when banks are complaining of an inability to lend owing to the
need to preserve capital and are also attempting to justify rises
in charges for consumers. (Paragraph 111)
16. The
calculation of remuneration in investment banking and at the top
of banks remains thoroughly dysfunctional. In many cases it is
still linked to inappropriate financial measures, often short-term,
while long-term risk is not adequately considered. Individuals
have incentives to be preoccupied with short-term leveraged growth
rather than sustainability and good conduct. (Paragraph 116)
17. Though
they have been much less generous than in investment banking,
poorly constructed incentive schemes in retail banking have also
hugely distorted behaviour. They are likely to have encouraged
mis-selling and misconduct. Senior management set incentive schemes
for front-line staff which provided high rewards for selling products
and left staff who did not sell facing pressure, performance management
and the risk of dismissal. It shows a disregard for their customers
and front-line staff that some senior executives were not even
aware of the strong incentives for mis-selling caused by their
own bank's schemes. These remuneration practices are ultimately
not in the interests of banks themselves, still less of the customers
they serve. (Paragraph 119)
Inadequate checks and balances
18. It
would be wrong to indulge in misplaced nostalgia about either
the friendly community bank manager of bygone days or the quintessentially
British culture of the City of London prior to the emergence of
the universal banking model. Nevertheless, changing incentives
in the sector, together with the impact of globalisation and technological
change, have eroded cultural constraints upon individuals' behaviour.
Banking now encompasses a much wider range of activities, has
fewer features of a professional identity and lacks a credible
set of professional bodies. (Paragraph 130)
19. The professions may not be
paragons, but they do at least espouse a strong duty of trust,
both towards clients and towards upholding the reputation of the
profession as a whole. In contrast, bankers appear to have felt
few such constraints on their own behaviour. Few bankers felt
a duty to monitor or police the actions of their colleagues or
to report their misdeeds. Banking culture has all too often been
characterised by an absence of any sense of duty to the customer
and a similar absence of any sense of collective responsibility
to uphold the reputation of the industry.
(Paragraph 135)
20. The
"three lines of defence" system for controlling risk
has been adopted by many banks with the active encouragement of
the regulators. It appears to have promoted a wholly misplaced
sense of security. Fashionable management school theory appears
to have lent undeserved credibility to some chaotic systems. Responsibilities
have been blurred, accountability diluted, and officers in risk,
compliance and internal audit have lacked the status to challenge
front-line staff effectively. Much of the system became a box-ticking
exercise whereby processes were followed, but judgement was absent.
In the end, everyone loses, particularly customers. (Paragraph
143)
Regulation: barking up the wrong tree
21. That
regulation is well-intentioned is no guarantee that it is a force
for good. Misconceived and poorly-targeted regulation has been
a major contributory factor across the full range of banking standards
failings. Regulators cannot always be expected to behave as disinterested
guardians who will pursue the "right" approach. They
are faced with complex challenges to which the appropriate solutions
are ambiguous and contested. They have not in the past always
risen to those challenges satisfactorily. They need to resist
the temptation to retreat into a comfort zone of setting complex
rules and measuring compliance. They also need to avoid placing
too much reliance on complex models rather than examining actual
risk exposures. Regulators were complicit in banks outsourcing
responsibility for compliance to them by accepting narrow conformity
to rules as evidence of prudent conduct. Such an approach is easily
gamed by banks, and is no substitute for judgement by regulators.
(Paragraph 158)
22. Retail
banking is characterised by high market concentration and substantial
barriers to entry. The limited switching between providers can
be seen as a symptom of this. There is insufficient market discipline
on banks to reduce prices and improve service. This lack of competition,
compounded by generally low levels of customer understanding of
financial products and services, is an important reason why banks
can sustain poor standards of conduct and do not seem to feel
the same pressure to respond to reputational damage as would be
the case in many other industries. (Paragraph 167)
23. Customers
are often ill-placed to judge the value of banking services that
they are offered. Banks have incentives to take advantage of these
customers by adding layers of complexity to products. A good deal
of the innovation in the banking industry makes products and pricing
structures more complex, hindering the ability of consumers to
understand and compare the different products. Regulators and
banks need to ensure that information provided is crystal clear
to enable comparison and choice. (Paragraph 172)
Incentives to pull in the wrong direction
24. Shareholders
are ill-equipped to hold bank boards to account. In particular,
institutional shareholders have incentives to encourage directors
to pursue high risk strategies in pursuit of short-term returns
and ignore warnings about mis-selling. Nonetheless, shareholder
pressure is not an excuse for the reckless short-termism witnessed
over recent years. Boards and senior management have shown a considerable
capacity to ignore shareholders' interests when it has suited
them. (Paragraph 176)
25. Auditors
and accounting standards have a duty to ensure the provision of
accurate information to shareholders and others about companies'
financial positions. They fell down in that duty. Auditors failed
to act decisively and fully to expose risks being added to balance
sheets throughout the period of highly leveraged banking expansion.
Audited accounts conspicuously failed accurately to inform their
users about the financial condition of banks. (Paragraph 181)
26. It
is widely held that credit rating agencies have business models
founded on a conflict of interest, whereby in most cases they
are paid by those who issue the financial products of which the
agencies purport to be the dispassionate assessors. The industry
also contains a barrier to entry which reduces competition in
the ratings industry: issuers are often unwilling to deal with
a number of agencies, and many issuers believe that investors
will want ratings by the well-known firms. This entrenches the
position of the three main agencies who continue to dominate the
market, notwithstanding their chequered forecasting record. There
have been insufficient signs of change. This would matter less
if the agencies were viewed as just another source of opinion,
but their ratings have come to enjoy an unwarranted status. This
is because rating agency scorings offer a convenient shorthand
to describe risk, not just for market participants, but particularly
for the regulators. (Paragraph 184)
27. The
tax bias that incentivises companies to favour debt over equity
did not by itself cause the financial crisis. The scale of its
impact on the incentives for banks to become highly leveraged
is unclear. But, at the very least, having a tax system that encourages
banks to take on more risk certainly does not help. The more forces
that are pulling in the wrong direction, the more difficult it
is to design the regulation required to restrain them. (Paragraph
188)
28. The
favourable treatment of banking by regulators and governments
has not merely been the consequence of smooth lobbyists seducing
naive politicians. The economic growth and tax revenues promised
by a booming sector over the relatively brief political cycle
dazzled governments around the world. This encouraged excess and
undermined regulators. Public anger with bankers has now dimmed
this effect, but its possible revival in calmer economic times,
when bankers are off the front pages, should remain a deep concern.
(Paragraph 190)
Insufficient downsides
29. The
distorted incentives in banking are nowhere more apparent than
in the asymmetry between the rewards for short-term success and
costs of long-term failure for individuals. Many bankers were
taking part in a one-way bet, where they either won a huge amount,
or they won slightly less and taxpayers and others picked up the
tab, even if some individuals paid a large reputational price.
Many have continued to prosper while others, including the taxpayer,
continue to foot the bill for their mistakes. There have been
a few isolated instances of individual sanction, but these have
rarely reached to the very top of banks. This sanctioning of only
a few individuals contributes to the myth that recent scandals
can be seen as the result of the actions of a few 'rotten apples',
rather than much deeper failings in banks, by regulators and other
parts of the financial services industry. (Paragraph 203)
30. Many
of the rewards have been for activities previously undertaken
within a partnership model, a model under which a more appropriate
balance between risk and reward exists. The return of these activities
to partnership-based vehicles such as hedge funds could help redress
the balance and is to be encouraged. (Paragraph 204)
Chapter 4: Tackling resistance to reform
It's all under control
31. The
Commission has been told that failures in banking standards were
the product of a system which is already being replaced, and that
current reforms will largely suffice. Bank leaders argue that
they are well on the way to completing the correction of the mistakes
that were made. Numerous regulatory reforms will supposedly ensure
that such mistakes will not, in any case, be allowed in future.
Significant progress has indeed already been made. However, the
Commission has concluded that reliance solely on existing reforms
and on the good intentions of those currently in charge of banks
will not be enough. (Paragraph 219)
32. The
majority of post-crisis regulatory reforms are aimed at improving
financial stability and removing the implicit government guarantee.
This can make an important contribution to banking standards.
However, many of these reforms have yet to be introduced or take
full effect, and there is convincing evidence that they will not
be taken to the point where the implicit taxpayer guarantee is
eliminated. The efficacy of such reforms will remain untested
until the next crisis. In any case, measures aimed at improving
financial stability will not remedy other underlying causes of
poor standards and culture. (Paragraph 220)
Risks to the competitiveness of the UK banking
sector
33. Banking
has been a great British strength, but for that reason is also
an important source of risk to Britain. A series of factors, considered
below, combine to give the UK an inherent advantage as a place
to do financial business. Properly harnessed, finance can greatly
add to nationwide prosperity. However, recent history has demonstrated
that, whether or not the benefits of a large banking sector have
been overstated, the risks were certainly understated. Given the
huge size of the banking sector in the UK relative to the overall
size of the economy, it is important that policy-makers and regulators
balance support for the sector with proper safeguards to limit
the potential damage it can do to the UK economy and to taxpayers
if things go wrong. The banking collapse of 2008 shows these risks
are very real. (Paragraph 224)
34. Policy-makers
should be aware of the risks of relocation, but should not be
held hostage by them. Around the world there is a move to stronger
regulation and to learning the lessons of what happened in the
run up to 2008. The UK must not be intimidated out of making the
changes necessary to protect the public by threats of bank relocation.
(Paragraph 232)
35. The
UK should do what is necessary to secure London's position as
a pre-eminent and well-regulated financial centre in order to
make sure that it represents an attractive base for whatever tomorrow's
financial sector may look like. High standards in banking should
not be a substitute for global success. On the contrary, they
can be a stimulus to it. (Paragraph 237)
36. Policy-makers
in most areas of supervision and regulation need to work out what
is best for the UK, not the lowest common denominator of what
can most easily be agreed internationally. There is nothing inherently
optimal about an international level playing field in regulation.
There may be significant benefits to the UK as a financial centre
from demonstrating that it can establish and adhere to standards
significantly above the international minimum. A stable legal
and regulatory environment, supporting a more secure financial
system, is likely to attract new business just as ineffective
or unnecessarily bureaucratic regulation is likely to deter it.
(Paragraph 247)
37. The
UK's ability to make necessary reforms to financial regulation
risks being constrained by the European regulatory process, which
is developing rapidly as Eurozone countries move towards banking
union. Some new financial regulation across the EU may be desirable
as a support for the Single Market. However, there are at least
two dangers for the UK. The first is that the prescriptive and
box-ticking tendency of EU rules designed for 27 members will
impede the move towards the more judgement-based approach being
introduced in the UK in response to past regulatory failures.
The second is that some EU regulations may limit the UK's regulatory
scope for unilateral action. This could mean moving at the speed
of the slowest ship in the convoy. This is a risk which the UK,
as a medium-sized economy hosting one of the world's two most
important financial centres, cannot afford. (Paragraph 255)
38. The
potential for regulatory reforms to drive some activities out
of banks and into "shadow banking" should not be viewed
as a reason not to act. The migration of some of the higher risk
activity currently conducted by banks to non-bank companies is
already happening on a large scale and, in many cases, this is
welcome. It is making some big banks smaller and simpler, shifting
some risks to structures better suited to handling them, and weakening
the links between these risks and the core of the banking system.
Shadow banks do not believe that they will be bailed out by the
taxpayer and those that run them often have their shirts on the
line. This move would, however, become problematic if, as happened
in the United States in 2008, highly-leveraged shadow banks became
over-exposed to core banking risks, for example related to maturity
transformation, and themselves become too big and interconnected
to fail. It is therefore essential that the Bank of England, FPC
and PRA take seriously the task of monitoring shadow banking.
(Paragraph 261)
Biting the hand that feeds us
39. Institutional
investors are misguided in their opposition to further change
in banking and its regulation. Shareholders have not been well-served
by poor banking standards in the past, having seen many of their
pre-crisis gains wiped out by the crash and by the cost of dealing
with conduct failures. In many cases, institutional investors
only had themselves to blame. They were scarcely alert to the
risks to their investments prior to the crash, but were mesmerised
by the short-term returns and let down those whose money they
were supposed to be safeguarding. With banks required to hold
more capital, the potential liability of shareholders will be
greater. If higher capital requirements make banks less vulnerable
to disasters in the future, those banks are a more attractive
investment. Further reforms will carry a cost in the short term,
but an effectively-reformed banking sector subject to less uncertainty
will be a better long-term recipient of investment. (Paragraph
270)
40. Banks
find themselves simultaneously exhorted to comply with costly
new regulations, strengthen their capital and liquidity, and yet
at the same time provide generous credit and cheap banking services
to all. It is important to recognise the tension between these
objectives, and to accept that beneficial reforms may also involve
some costs, particularly if the implicit subsidy from taxpayers
is to be reduced. These costs will need to be borne not only by
shareholders and employees, but also in part by customers who
will have to pay the appropriate price for the services they receive.
The best way of ensuring that these costs are kept low is to ensure
that there is effective competition and that market discipline
applies to the banking sector. However, the commonly-heard argument
that forcing banks to raise capital will hurt lending is false.
Banks may well be reluctant to raise new equity capital since
this depresses their return on equity and might be expensive,
diluting current shareholdings. Nevertheless, if they do raise
capital of the right kind this provides new funds which can be
lent out to the economy, since capital does not simply sit idly
on the balance sheet. If regulators allow banks discretion over
how they achieve higher risk-weighted asset ratios or leverage
ratios, some banks may choose to reduce lending and shrink their
balance sheets instead of raising new capital. However, regulators
can demand an increase in absolute capital levels to avoid this,
as the Financial Policy Committee has already made clear. (Paragraph
271)
Overcoming resistance
41. Faced
with proposals for solutions that match the depth and severity
of the crisis in banking standards and culture, politicians will
be given many reasons to shy away from the necessary reforms.
Opponents of further reforms claim that such reforms have been
rendered unnecessary by reforms already being implemented, that
they will damage the competitiveness of the City and cost jobs,
and that they will harm banks' ability to support the rest of
the economy. (Paragraph 272)
42. The
UK's competitiveness will be threatened in the long-term by blindness
to the dangers associated with poor banking standards and culture.
If the arguments for complacency and inaction are heeded now,
when the crisis in banking standards has been laid bare, they
are yet more certain to be heeded when memories have faded. If
politicians allow the necessary reforms to fall at one of the
first hurdles, then the next crisis in banking standards and culture
may come sooner, and be more severe. (Paragraph 273)
Chapter 5: Better functioning markets
A vital utility role
43. The Commission believes that
banking the unbanked should be a customer service priority for
the banking sector. It should be a right for customers to open
a basic bank account irrespective of their financial circumstances.
The Commission expects the major banks to come to a voluntary
arrangement which sets minimum standards for the provision of
basic bank accounts. The failure of the most recent industry talks
and the apparent unwillingness of some banks to engage constructively
in coming to an agreement is a cause for concern. These standards
should include access to the payments system on the same terms
as other account holders, money management services and free access
to the ATM network. A withdrawal of free access to ATMs would
constitute evidence of a race to the bottom. The industry should
also commit to a guarantee that an individual satisfying a clearly-defined
set of eligibility criteria will not be refused a basic bank account.
Such an agreement should outline how minimum standards are to
be upheld and updated in the light of technological change; how
the right to a basic bank account should be promoted to the public,
and particularly the unbanked; and how the obligation to provide
basic bank accounts should be distributed between providers. Greater
consistency of approach between banks and greater cooperation
between them should enable a more cost-effective service to the
providers than is possible with the current patchwork of individually
designed schemes. In the event that the industry is unable to
reach a satisfactory voluntary agreement on minimum standards
of basic bank account provision within the next year, the Commission
recommends that the Government introduce, in consultation with
the industry, a statutory duty to open an account that will deliver
a comprehensive service to the unbanked, subject only to exceptions
set out in law.
(Paragraph 290)
44. It
is important to ensure that the money being spent by the banks
in this area is being spent in a way which represents best value
for money. It may be the case that cooperation between the banks
on basic bank account provision could yield cost savings, as could
cooperation with other bodies. The industry, working together
with other interested parties such as community development finance
institutions, credit unions, consumer groups and those representing
segments of society who are heavy users of basic bank accounts,
need to consider whether such provision could be delivered in
alternative ways which ensures high quality cost-effective provision.
For example, an alternative approach could be for banks community
development finance institutions, credit unions and other providers
to work together in city-based or regional partnerships to develop
local strategies for ensuring that the right to a basic bank account
can be realised by all. The Commission recognises that participation
in these partnerships may need to be obligatory, and that evidence
of commitment to the development of local and community-based
financial platforms should be required for banks to avoid mandatory
participation in basic bank accounts. (Paragraph 291)
45. The
Government also needs to ensure that the agreement, voluntary
or not, is underpinned by a requirement on the FCA to uphold minimum
standards. As part of its role in this area, the FCA should have
responsibility for collating and publishing data on the market
share of providers in the basic bank account market. If the FCA
does not currently have sufficient powers to assume this role,
it would need to be given them. The provision of statistics is
needed on the numbers of unbanked people, together with figures
showing each bank's share of the basic account market in relation
to its overall current account market share. This data should
be periodically produced by the FCA. (Paragraph 292)
46. Many
individuals, businesses and geographical areas are poorly served
by the mainstream banking sector. Many consumers have consequently
opted for high-cost credit from payday lenders, some of whose
practices have been a source of considerable concern. There can
be a role for community finance organisations in supporting those
whom the mainstream banking sector appears uninterested in serving.
Given the benefits of a collaborative relationship, the BBA and
the banks should be held to their commitment to refer declined
loans to CDFIs. The effectiveness of current tax incentives, including
Community Investment Tax Relief, intended to encourage investment
in CDFIs by banks and other funders, should also be reviewed by
the Treasury and, where necessary, re-designed to be more effective.
(Paragraph 298)
47. The
Commission recommends that banks be required to commit to investigating
ways in which they can provide logistical, financial or other
forms of assistance to community finance organisations, in order
to ensure that the community finance sector becomes strong enough
over a period of years to work as a full partner with banks so
that issues of unbanked individuals and communities are addressed.
(Paragraph 299)
48. Increased
disclosure of lending decisions by the banks is crucial to enable
policy-makers more accurately to identify markets and geographical
areas currently poorly served by the mainstream banking sector.
The industry is currently working towards the provision of such
information. We welcome this. It will be important to ensure that
the level of disclosure is meaningful and provides policy-makers
with the information necessary accurately to identify communities
and geographical areas poorly served by the mainstream banking
sector. The devil will be in the detail of the disclosure regime
which is put in place, including, for example, the question of
whether such data will be disaggregated by institution and whether
it goes beyond lending to small businesses. The Commission therefore
supports the Government's proposal to legislate if a satisfactory
regime is not put in place by voluntary means. (Paragraph 300)
Competition in retail banking
49. We
concur with the evidence received which has stressed the role
that competition can, and should, play to bring about higher standards
in the banking sector. The discipline of the market can and should
be an important mechanism for raising standards as well as increasing
innovation and choice and improving consumer outcomes. Effective
market discipline, geared to the needs of consumers, can be a
better mechanism for improving standards and preventing consumer
detriment than regulation, which risks ever more detailed product
prescription. A policy approach which focuses on detailed product
regulation alone could inhibit innovation and choice for consumers.
(Paragraph 306)
50. The
fact that the largest banks have gained their dominant positions
in retail banking markets, in part through their receipt of a
'too important to fail' subsidy and bail-outs, is a very unhealthy
situation for effective competition. These increases in concentration
are bad for competition and bad for stability. (Paragraph 312)
51. The
prudential reforms outlined in the FSA's review of barriers to
entry are to be welcomed as a long overdue correction of the bias
against market entrants, who are, at least initially, unlikely
to be of systemic importance. Although the concerns of challenger
banks in this area appear to have largely been addressed, the
practical application of the regulatory authorities' laudable
statements needs to be monitored closely. (Paragraph 323)
52. In its final publication, the
FSA reformed an authorisation process that has long stifled entry
to the banking market. This reform was welcome, but long overdue.
The Commission supports both the specific proposals and the broader
approach set out in the review for encouraging new entry. However,
for a very long time, the regulatory authorities in the UK have
displayed an instinctive resistance to new entrants. This conservatism
must end. The regulators' approach to authorising and approving
new entrants, particularly those with distinct models, will require
close monitoring by the Government and by Parliament, and the
regulator should report to Parliament on progress in two years
time. (Paragraph 327)
53. We
welcome the Government's Damascene conversion to bring payments
systems under economic regulation and establish a new competition-focused,
utility-style regulator for retail payments systems, along the
lines originally proposed by Sir Donald Cruickshank in his 2000
review of competition in UK banking. The current arrangements,
whereby a smaller bank can only gain access to the payments system
via an agency agreement with one of the large banks with which
it is competing, distort the operation of the market. Such agency
agreements place small banks at a disadvantage, because the large
banks remain in a strong position to dictate the terms on which
indirect access to the payments system can be secured by smaller
banks, even if there is currently no evidence of them doing so.
The Government's proposed reforms will, however, continue to leave
ownership of the payments system largely in the hands of the large
incumbent banks. Continued ownership of the payments system by
the large banks could undermine the proposed reforms, in view
of the scope such ownership gives them to create or maintain barriers
to entry. The Commission therefore recommends that the merits
of requiring the large banks to relinquish ownership of the payments
system be examined and that the Government report to Parliament
on its conclusions before the end of 2013. (Paragraph 334)
54. The
Commission agrees strongly that local government deposits should
only be held with financial institutions that can demonstrate
their robust financial strength. A high credit rating is an important
indicator of financial strength. However, it is just one indicator
of financial strength. The suggestion of the Department for Communities
and Local Government (DCLG) that deposits are placed with institutions
with high credit ratings can have an adverse effect on banks without
formal ratings. By effectively cutting off from access entrants
to this source of funding, new and small banks face an unlevel
playing field. The consequence is that, while the Government stresses
the importance of encouraging new entry into the retail banking
market, the current DCLG guidance acts in a way that puts new
entrants at a competitive disadvantage. (Paragraph 338)
55. Deposits
held by financial institutions originating from central or local
government make up a sizeable proportion of the UK deposit market.
Provided that other measures of credit worthiness are in place,
it would be a source of concern to the Commission if the guidance
or rules in this area prevented such deposits from being held
by small banks or other institutions without a formal rating.
If so, this would constitute yet another example of an unlevel
playing field between the large incumbent banks and small or new
banks in the retail market which needs to be addressed. As a result,
the Commission recommends that the DCLG review its guidance in
this area to see whether it penalises new banks and consider the
scope for such institutions to demonstrate credit-worthiness as
well as liquidity and stability in other ways. A bank's strength
should not be measured solely by its credit rating, especially
as the financial crisis demonstrated how many banks with strong
pre-crisis credit ratings ran into serious difficulties. (Paragraph
339)
56. Diversity
of provision in the retail banking market matters. The Commission
sees value not just from more new banks with orthodox business
models, but also from alternative providers. Diversity of provision
can increase competition and choice for consumers and make the
financial system more robust by broadening the range of business
models in the market. The UK retail market lacks diversity when
compared to other economies, and this has served to reduce both
competition and choice to the obvious detriment of consumers.
The Commission strongly supports moves to create a more diverse
retail market. However, the Commission is not persuaded of the
case for adding another 'have regard' duty for the Financial Conduct
Authority at this time, beyond the current competition and access
provisions. Instead, the regulator should ensure that other forms
of provision are not put at a disadvantage. This should be reviewed
by the FCA within four years and be the subject of a report to
Parliament. The PRA will need to support the FCA in this wherever
possible, by avoiding prudential requirements which deter alternative
business models emerging or place them at a competitive disadvantage.
(Paragraph 343)
57. Peer-to-peer
and crowdfunding platforms have the potential to improve the UK
retail banking market as both a source of competition to mainstream
banks as well as an alternative to them. Furthermore, it could
bring important consumer benefits by increasing the range of asset
classes to which consumers have access. This access should not
be restricted to high net worth individuals but, subject to consumer
protections, should be available to all. The emergence of such
firms could increase competition and choice for lenders, borrowers,
consumers and investors. (Paragraph 350)
58. Alternative
providers such as peer-to-peer lenders are soon to come under
FCA regulation, as could crowdfunding platforms. The industry
has asked for such regulation and believes that it will increase
confidence and trust in their products and services. The FCA has
little expertise in this area and the FSA's track record towards
unorthodox business models was a cause for concern. Regulation
of alternative providers must be appropriate and proportionate
and must not create regulatory barriers to entry or growth. The
industry recognises that regulation can be of benefit to it, arguing
for consumer protection based on transparency. This is a lower
threshold than many other parts of the industry and should be
accompanied by a clear statement of the risks to consumers and
their responsibilities. (Paragraph 356)
59. The
Commission recommends that the Treasury examine the tax arrangements
and incentives in place for peer-to-peer lenders and crowdfunding
firms compared with their competitors. A level playing field between
mainstream banks and investment firms and alternative providers
is required. (Paragraph 359)
Enabling customer choice
60. The ICB, the OFT and others
have been clear that the new switching service and the per-switch
fee should not impose disproportionate costs on new entrants or
small banks. The Commission concurs and finds it difficult to
envisage any circumstance in which it would be appropriate for
the per-switch fee to be borne wholly by either the new bank acquiring
the customer or by the bank losing the customer.
(Paragraph 380)
61. The
Commission welcomes the introduction of the seven-day switching
service. It should improve the switching process for consumers
and increase the level of competition in the current account market.
We consider it vital that the launch of service be fully publicised
and that any practical problems that emerge be addressed with
urgency. We regret the fact that neither the Government nor the
Payments Council have established benchmarks to measure the impact
of the new service. (Paragraph 384)
62. A
common utility platform is an intellectually appealing idea and
has the potential to introduce much greater competition into the
market than a seven-day switching service. The benefits of a common
utility platform include improving competition through significantly
faster switching times and reducing the risk that consumers will
encounter administrative problems as a result of switching their
bank account provider. Financial stability benefits, supporting
the FPC's objectives, that could result from the implementation
of a common utility platform include raising the general levels
of transparency in the money system, improving bank resolvability
in the case of bank failure and encouraging banks to make much
needed investment into their patchy and outdated in-house IT systems.
However, the idea is insufficiently developed to be recommended
by the Commission. It is impossible to make a judgement about
its merits or about related proposals for account portability
without a much clearer idea about the cost, benefits and the technical
feasibility of each. It is also extremely disappointing that no
independent technical study of account portability has been conducted,
despite a request by the Treasury Committee over two years ago.
The vagueness of the proposals put to the Commission is disappointing.
(Paragraph 385)
63. We
were concerned that the largest banks object very strongly to
bank account portability. While there is some evidence that individual
banks may have done some work on the costs of account portability,
this does not appear to have been accompanied by a comprehensive
consideration of all the benefits of portability. This gives the
impression that their objections are instinctive and, arguably,
that they are opposed to any reform that could encourage competition.
The lack of an independent regulator, a matter being considered
by the Government, may help to explain why no real progress has
been made on this matter. (Paragraph 386)
64. The
Commission recommends that the Government immediately initiate
an independent study of the technical feasibility, costs and benefits
of the full range of options for reform in this area. Such a study
must be conducted by an independent body rather than one linked
to the industry. To this end, the Commission recommends that the
Treasury establish an independent panel of experts to consult
widely and report on portability. The panel should not have current
industry representatives amongst its membership. Membership of
the panel should be drawn from banking IT specialists, retail
banking competition experts, economists, representatives of retail
consumers and small businesses and resolution specialists. It
should report within 6 months of its establishment on switching
and within 12 months on other issues. The panel, as part of its
work, should examine the implications of the central storage of
consumer data, implicit in the common utility platform proposal.
It should also examine the scope for reducing downwards from seven
days the time it will take to switch under the new switching service.
(Paragraph 387)
A market investigation reference
65. Both
the ICB and the OFT have carefully considered the case for making
a market investigation reference to the Competition Commission
with respect to the UK banks. Their decision not to propose or
make such a reference has had nothing to do with progress in increasing
competition within the sector thus far. On the contrary, the OFT,
in their recent review of the personal current market, were extremely
critical of the lack of progress in increasing competition in
this part of the retail market. They concluded that concentration
remained high, new entry infrequent and switching low, which "resulted
in a market in which lack of dynamism from providers combines
with customer inertia to deliver sub-optimal outcomes for consumers
and the economy". The OFT review took place against the backdrop
of a rise in concentration in parts of the retail banking market,
following the financial crisis. (Paragraph 401)
66. Both
the ICB and the OFT have previously held back from referring the
sector to the Competition Commission in the hope that a series
of reforms currently in the pipelineincluding the new 7-day
switching service, the establishment of a pro-competition FCA
and the Lloyds and RBS divestmentswould increase competition
in the market. Both divestments have failed. Regardless of whether
these divestments can be put back on track, it looks increasingly
unlikely that a significant new challenger bank will soon emerge
from them. Additionally, given the delays in the divestmentswhich
now most likely will take until at least 2014 to be completedit
will not be possible to assess whether they have fundamentally
altered competition in the sector until 2017 or 2018 at the earliest.
This is too long to wait and should not be used as a justification
for, yet again, pushing a market investigation reference into
the long grass. (Paragraph 402)
67. The
Commission has considered the case for an immediate market investigation
reference. There is a strong case for doing so. However, there
is also a strong case against an immediate referral. A large number
of regulatory reforms to the banking sector are already in train,
as well as those recommended by this Commission. An immediate
Competition Commission referral would further add to the burden
of uncertainty on the sector and would divert the banks from their
core objective of recovery and lending to the real economy. We
are persuaded that arguments for delay have some merit, but should
not be allowed to serve as an argument for indefinite inaction.
The scale of the problems in the banking sector, combined with
their systemic importance, means they will necessarily continue
to be subject to regulatory intervention and upheaval for many
years to come. A second argument against an immediate referral
is that reform measures already in train will significantly increase
competition in the sector. We agree that, while the failure to
date of the divestments is a disappointment, a series of reforms
in the pipeline have potential to have this effect. (Paragraph
403)
68. The
Commission recommends that the Competition and Markets Authority
immediately commence a market study of the retail and SME banking
sector, with a full public consultation on the extent of competition
and its impact on consumers. We make this recommendation to ensure
that the market study is completed on a timetable consistent with
making a market investigation reference, should it so decide,
before the end of 2015. We note that, under section 132 of the
Enterprise Act 2002, the Secretary of State for Business, Innovation
and Skills has the power to make a reference himself, should he
not be satisfied with a decision by the OFT not to make a reference,
or the time being taken by the OFT to make a decision on a reference.
(Paragraph 404)
Tackling the information mismatch
69. Banks
need to demonstrate that they are fulfilling a duty of care to
their customers, embedded in their approach to designing products,
providing understandable information to consumers and dealing
with complaints. A bank has a responsibility to ensure that customers
have had a reasonable opportunity to understand a transaction,
having regard to their knowledge and personal circumstances. The
FCA now has a mandate under its consumer protection objective
to enforce this responsibility. Banks should assess whether they
are fulfilling it by commissioning periodic independent checks
on customers' understanding of the transactions they have entered
into and the outcomes achieved. The Commission recommends that
the FCA examine periodically whether banks' systems for carrying
out their own assessments are adequate. (Paragraph 416)
70. The
Commission welcomes the FCA's interest in pursuing transparency
of information as a means of exercising its competition objective.
Informed consumers are better placed to exert market discipline
on banking standards. The Commission recommends that the FCA consult
on a requirement to publish a range of statistical measures to
enable consumers to judge the quality of service and price transparency
provided by different banks. Such measures should be based on
customer outcomes rather than only on customer satisfaction levels.
Amendment of section 348 of FSMA is likely to be required to facilitate
the publication of appropriate information about the quality of
service and price transparency. (Paragraph 423)
Tackling the legacy of RBS
71. The
Royal Bank of Scotland Group is one of the UK's largest domestic
banks and plays a crucial role in the UK economy, particularly
in relation to small and medium enterprises. The current state
of RBS and its continued ownership by the Government create serious
problems for the UK economy, despite the commendable work of Stephen
Hester and his team in cleaning up its balance sheet since 2008.
RBS's capital position remains weak, impairing its ability to
provide the levels of lending or competition needed for the restoration
of vitality to the banking sector and for the UK's full economic
recovery. RBS continues to be weighed down by uncertainty over
legacy bad assets and by having the Government as its main shareholder.
Such problems for one of the UK's largest banks weaken confidence
and trust in banks and bank lending. They also undermine wider
economic confidence and investment activity even for firms not
facing immediate credit constraints. (Paragraph 450)
72. UKFI
was established by the previous Government to manage the Government's
shareholdings in the State-owned and partly State-owned banks,
but also crucially to ensure that Government was not involved
in the day-to-day running of these institutions, thereby ensuring
that they would be run on commercial lines, thus facilitating
an early return to the private sector. These were sensible aims,
but they have not been fulfilled. Instead, the Government has
interfered in the running of the two partly State-owned banks,
particularly RBS. On occasions it has done so directly, on others
it appears to have acted indirectly, using UKFI as its proxy.
The current arrangements are clearly not acceptable. Whatever
the degree of interference, UKFI will increasingly be perceived
as a fig leaf to disguise the reality of direct Government control.
The current arrangements therefore cannot continue. It could be
argued that bolstering UKFI's independence from the Government
is the way forward. It may be possible to bolster UKFI's independence,
but this would be extremely unlikely to end political interference
in the State-owned banks. In the present economic and political
climate, governments will continue to be tempted to influence
or intervene in the banks. The Commission has concluded that UKFI
should be wound-up and its resources absorbed back into the Treasury.
(Paragraph 451)
73. In
considering reprivatisation of RBS, the Government should try
to ensure best value for the taxpayer and the wider interests
of the UK economy. (Paragraph 460)
74. The
current plan for dealing with RBS risks being insufficient. Although
RBS management claim they will be ready to at least begin flotation
of the bank in 12 to 18 months, others have challenged the credibility
of this claim. There remain on the balance sheet assets with uncertain
value and limited relevance to the UK economy. (Paragraph 461)
75. The
Government's strategic priority for RBS must be to create strong
and competitive provision of its core services, including UK retail
and corporate lending, freed from its legacy problems. This is
essential, not just for the SME and retail sectors that RBS primarily
serves, but also in the interests of the broader economy as a
whole. RBS and the Government claim to share these reflections.
However, the Commission doubts that the current proposals will
achieve this outcome sufficiently quickly or decisively. (Paragraph
496)
76. The
current strategy for returning RBS to the private sector has been
allowed to run for five years. Progress has been made but it is
time to look at this afresh. The case has been put to the Commission
for splitting RBS into a good bank and bad bank. There may be
significant advantages in doing so, including focusing the good
bank on UK retail and commercial banking and, by freeing it from
legacy problems, strengthening its ability to lend and making
it a more attractive investment proposition which could subsequently
be privatised at a good price. However, there are also important
questions which need to be answered before such a course of action
could be recommended. These questions include:
- The cost and risk to the taxpayer;
- What assets would go into the bad bank and what
would be left behind in the good bank;
- The case for a wider split between retail and
investment banking at RBS given the need to change the past culture
at the bank;
- The potential State Aid consequences on the shape
of RBS of a further injection of state funds in terms of divestments
or other involuntary restructuring; and
- Whether or not such a course of action would
be capable of returning the good part of the bank to the private
sector more quickly than the course currently being pursued by
the RBS management. (Paragraph 497)
77. The
Commission did not take extensive evidence on these questions
and most can only be answered on the basis of detailed analysis
conducted by those with access to the necessary informationnamely
the Government and RBS. The Commission recommends that the Government
immediately commit to undertaking such detailed analysis on splitting
RBS and putting its bad assets in a separate legal entity (a 'good
bank / bad bank' split) as part of an examination of the options
for the future of RBS. We endorse the Treasury Committee's call
for the Government to publish its work on a good bank / bad bank
split. If the operational and legal obstacles to a good bank /
bad bank split are insuperable, the Government should tell Parliament
why and submit its analysis to scrutiny. (Paragraph 498)
78. The
Commission envisages that this examination would be published
by September 2013 and examined by Parliament. At the same time,
the Government should also examine and report to Parliament on
the scope for disposing of any RBS good bank as multiple entities
rather than one large bank, to support the emergence of a more
diverse and competitive retail banking market. (Paragraph 499)
Lloyds Banking Group
79. Lloyds
Banking Group has suffered far less from the effect of public
ownership and the perception of political interference than RBS.
Lloyds, a mainly retail and commercial bank, has also largely
avoided the same intense public focus on remuneration policies.
For these reasons the case for intervention in Lloyds is far weaker
than is the case with respect to RBS. Lloyds appears better placed
to return to the private sector without additional restructuring.
(Paragraph 511)
Financial literacy
80. Waves
of mis-selling and other forms of detriment suffered by consumers
in the retail banking market reflect not just widespread financial
illiteracy, but may also be the result of weaknesses in numeracy
and literacy skills of some consumers. Wider concerns about the
need for higher numeracy and literacy skills fall outside the
scope of our inquiry, but they have contributed to poor levels
of financial literacy. A more financially literate population
will be better capable of exerting meaningful choice, stimulating
competition and exerting market discipline on banks, which, in
turn, can drive up standards in the industry. Greater financial
literacy can also contribute to social mobility. Industry, regulators
and governments must avoid a situation where the banks design
ever more complex products and then blame consumers for not being
financially literate enough to understand them. Alongside greater
financial literacy, there is a need for a relentless drive towards
the simplification of products and the introduction of clear,
simple language. Mis-selling and undesirable cross-selling are
very unlikely to be eliminated through higher financial literacy,
but improvements to such literacy will help bear down on those
problems and be more effective, in many cases, than ever more
detailed conduct regulation. The counterpart of irresponsible
lending is, in many instances, uninformed consumers. Regulation
remains essential, but risks restricting choice and innovation.
Increased competition, underpinned by financially literate consumers,
can do much more to address irresponsible lending. To this end,
we welcome the announcement by the Government earlier this year
that it will include both financial education and financial mathematics
in the National Curriculum. (Paragraph 519)
Complaints and redress
81. The
narrow definition of an "unsophisticated customer" used
to determine eligibility for access to the Financial Ombudsman
Service (FOS) for redress has been highlighted as problematic
by the wave of cases relating to interest rate swap mis-selling
to small businesses. Many small businesses have fewer than 10
employees. Such businesses are particularly vulnerable to potential
exploitation by the banks they rely upon for finance, particularly
in the case of complex derivative products. The Commission recommends
that the FCA consult on options for widening access to the FOS.
(Paragraph 523)
82. The
large banks have a poor track record when it comes to complaints
handling. This is clearly demonstrated by the high uphold rate
by the Financial Ombudsman Service, especially when it comes to
handling customer complaints regarding PPI. This is unacceptable
and has clearly contributed to customers lack of trust in banks.
The Commission expects to see a significant improvement in bank
performance in this area. (Paragraph 529)
83. A
line will eventually need to be drawn under the PPI debacle, but
that line will need to be drawn carefully and in a way that ensures
that consumers do not lose out unfairly. Consumers require clarity
about whether or not the PPI mis-selling scandal may have affected
them personally. To deliver this clarity, the Commission recommends
that the FCA urgently consider again the case for requiring banks
to write to all identified customers, except those who have already
initiated a PPI complaint or been contacted as part of any discrete
FSA-led PPI process in the past, and report to Parliament on the
outcome of its considerations. (Paragraph 530)
84. The
evidence the Commission has received suggests that too often the
banks have not taken customer complaints seriously. Many banks
have had very high percentages of their complaints upheld by the
FOS for far too long. The Commission recommends that the regulators
consider this as a matter of urgency. This needs to change with
banks motivated to respond to complaints appropriately the first
time round. The Commission believes that one way to incentivise
this behaviour would be for the FOS case handling fee not to apply
to banks where the FOS finds that the bank has managed a customer's
complaint fairly in the first instance. Conversely, banks who
are found not to have handled a complaint appropriately would
face a higher case handling fee. The Commission recommends that
the regulators consider this as a matter of urgency. (Paragraph
532)
Transparency in wholesale and investment banking
85. Cross-selling
and a lack of price transparency are not restricted to retail
banking. Parts of investment banking are also characterised by
opaque fee structures and some highly sophisticated companies
have entered into complex transactions that they have not fully
understood. This should not usually be an area for regulatory
intervention: the principle of caveat emptor acts as an
important force for market discipline. The regulator should not
seek to shield sophisticated customers from the consequences of
their poor decisions. However, it should be their duty, wherever
possible, to ensure maximum price transparency at every level
of banking. The lack of this transparency appears to be a problem
even for sophisticated end users of, for example, transition management
services. (Paragraph 536)
Chapter 6: A new framework for individuals
What's wrong with the Approved Persons Regime
86. As
the primary framework for regulators to engage with individual
bankers, the Approved Persons Regime is a complex and confused
mess. It fails to perform any of its varied roles to the necessary
standard. It is the mechanism through which individuals can notionally
be sanctioned for poor behaviour, but its coverage is woefully
narrow and it does not ensure that individual responsibilities
are adequately defined, restricting regulators' ability to take
enforcement action. In principle, it is the means by which the
regulator can control those who run banks, but in practice it
makes no attempt to set clear expectations for those holding key
roles. It operates mostly as an initial gateway to taking up a
post, rather than serving as a system through which the regulators
can ensure the continuing exercise of individual responsibility
at the most senior levels within banks. The public are rightly
appalled by the small number of cases in which highly-paid senior
bankers have been disciplined for the costly mistakes they have
allowed to occur on their watch. (Paragraph 564)
87. Faced
with the weaknesses of the Approved Persons Regime laid bare by
the failures of individuals in recent years, the FSA responded
to the need for reform with dilatoriness, seemingly paralysed
by the operational deficiencies of the existing system and unwilling
to contemplate moving away from the familiarity it represents.
Changes first mooted in January 2010 and agreed in September that
year have gone back to the drawing board and been made subject
to a further consultation, preceded by a pilot review and then
a full review. (Paragraph 565)
88. The
FSA and its successors have proposed changes to the Approved Persons
Regime, but there is a risk that these may be pursued with the
timid approach of recent years. We have considered the case for
reform of the Approved Persons Regime, but have concluded that
incremental change will no longer suffice. A new regulatory framework
for individuals within banking is urgently needed, and it cannot
be secured by adding new layers on the rickety foundations of
the Approved Persons Regime. (Paragraph 566)
Making a choice
89. Poor
standards in banking and the public's response to them have generated
an impetus within the banking industry to make proposals for professional
banking standards. This impetus is welcome and must be harnessed.
Some progress can be achieved through the emergence of a credible
professional body in banking, and the next section identifies
important milestones in such a process. (Paragraph 596)
90. However,
it is questionable whether the business of banking possesses sufficient
characteristics of a profession to lend itself to direct control
through a professional body. "Banking" involves a wide
range of activities and lacks the large common core of learning
which is a feature of most professions. It is a long way from
being an industry where professional duties to customers, and
to the integrity of the profession as a whole, trump an individual's
own behavioural incentives. A professional body alone does not
guarantee high standards, as illustrated by the varied scandals
in a range of other sectors where such bodies exist. (Paragraph
597)
91. There
are also very substantial risks of duplication between the powers
and role of a professional standards body and those of regulators,
as well as risks that the creation of such a body could become
a focus of public policy, diverting attention from the changes
that are urgently needed within the existing regulatory framework.
(Paragraph 598)
Milestones for a professional body
92. If
a unified professional body for banking in the UK is to emerge,
the onus should lie on the industry itself to maintain the impetus
for its development. Such a body needs first and foremost to be
created through the will, and with the resources, of banks and
those who work in the UK banking sector. The Commission's aim
in this section is to identify milestones for its development
and to assist in fostering its establishment and growth. However,
the emergence of a professional body should be consistent with
the wider regulatory and legislative reforms needed in banking.
It must not be seen as a necessary precursor to those reforms,
still less as a substitute for them. (Paragraph 599)
93. Banks
maintain that there would be benefits if they were to adopt, implement
and commit to enforce a single code of conduct prepared by a unified
professional body, which reflected a higher set of standards and
expectations for individual behaviour than those required by the
regulator. Providing statutory powers to a professional body would
mean either stripping away many powers from the regulators, including
the new powers that we propose in this and subsequent chapters,
or risking double jeopardy for individuals. No proponents of a
professional body have come forward with a plan which the Commission
believes is credible for how to address this problem. (Paragraph
600)
94. While
we support the creation of a professional standards body to promote
higher professional standards in banking, the case for it to share
or take over formal responsibility for enforcement in banking
will only gradually be able to prove itself and so we do not recommend
the establishment of such a body as an alternative to other regulatory
measures. However, preliminary work to establish a professional
body should begin immediately as a demonstration that commitment
to high standards is expected throughout banking and that individuals
are expected to abide by higher standards than those that can
be enforced through regulation alone. On the basis of our assessment
of the nature of the banking industry, we believe that the creation
of an effective professional body is a long way off and may take
at least a generation. It is therefore important that the trajectory
towards professionalisation is clearly signalled immediately and
that initial practical proposals for such a body are tabled at
an early stage. Work can begin immediately on bodies for the most
readily identifiable parts of banks which would benefit from professional
standards. These include retail banking, the most senior levels
and specialist areas such as insolvency and debt recovery. (Paragraph
601)
95. An
important milestone on the road to the successful development
of a professional standards body would be that it could claim
comprehensive coverage of all banks with operations in the UK.
If banks were to decline to assist in a body's development, or
to seek to resile from participation in due course, the credibility
and effectiveness of the body would be significantly damaged.
(Paragraph 602)
96. A
unified professional body for banking should have no need of public
subsidy, either directly or indirectly. We would expect such a
body to be funded by participating banks and individual qualified
members. However, it would also need to establish independence
from the outset, through its forms of governance, its disciplinary
procedures and through the personnel at senior levels. The body
must never allow itself to become a cosy sinecure for retired
bank chairmen and City grandees. Just as importantly, it must
eschew from the outset and by dint of its constitution any role
in advocacy for the interests of banks individually or collectively.
(Paragraph 611)
The Senior Persons Regime
97. In
the remaining sections of this chapter we set out the three main
pillars of a new system to replace the Approved Persons Regime:
- A Senior Persons Regime to replace the Significant
Influence Function element of the Approved Persons Regime. This
should provide far greater precision about individual responsibilities
than the system that it replaces, and would serve as the foundation
for some of the changes to enforcement powers and approach that
we recommend in Chapter 10;
- A Licensing Regime to replace the Approved Persons
Regime as the basis for upholding individuals' standards of behaviour,
centred on the application of a revised set of Banking Standards
Rules to a broader group than those currently covered by the Statement
of Principles for Approved Persons; and
- Reform of the register to support the first two
pillars and ensure that relevant information on individuals can
be captured and used effectively. (Paragraph 612)
98. The
Commission recommends that the Approved Persons Regime be replaced
by a Senior Persons Regime. The new Senior Persons Regime must
ensure that the key responsibilities within banks are assigned
to specific individuals who are aware of those responsibilities
and have formally accepted them. The purposes of this change are:
first, to encourage greater clarity of responsibilities and improved
corporate governance within banks; second, to establish beyond
doubt individual responsibility in order to provide a sound basis
for the regulators to impose remedial requirements or take enforcement
action where serious problems occur. This would not preclude decision-making
by board or committee, which will remain appropriate in many circumstances.
Nor should it prevent the delegation of tasks in relation to responsibilities.
However, it would reflect the reality that responsibility that
is too thinly diffused can be too readily disowned: a buck that
does not stop with an individual stops nowhere. (Paragraph 616)
99. The
Senior Persons Regime should apply to all banks and bank holding
companies operating in the UK. The Commission would expect that
the Senior Persons Regime would cover a narrower range of individuals
than those currently in Significant Influence Functions. Many
of the people in these functions are not really senior decision-takers.
Taking them out of scope, though still subject to the Licensing
Regime that we propose below, would allow the Senior Persons Regime
to focus much more clearly on the people who really run banks
and who should stand or fall by their role in decision-making.
Beyond board and executive committee members, who should always
be within scope, primary responsibility for identifying which
individuals fall within the regime and how their responsibilities
are defined should rest in the first instance with the banks themselves.
We would expect such responsibilities to cover both prudential
and conduct issues, such as product design. It should not be for
the regulator to prescribe how banks structure their management,
because it is important that banks retain the flexibility to do
this in the most appropriate way for their business. (Paragraph
617)
100. The
Commission recommends that regulators set out in guidelines how
responsibilities are to be identified and assigned, and should
have the power to take action against firms when it is satisfied
that they are not following these guidelines. We would expect
these to include the points below:
- All key activities that the business undertakes
or key risks to which it is potentially exposed should be assigned
to a Senior Person;
- The assignment of formal responsibilities should
be aligned with the realities of power and influence within a
bank and should reflect the operation of collective decision-making
mechanisms;
- Individuals should be fit and proper to carry
out responsibilities assigned to them, and be able to demonstrate
the necessary skills and experience;
- Responsibilities may be shared only where they
are generic to the office, such as a non-executive member of the
board; otherwise, they should be specific to an individual;
- A Senior Person cannot report directly to anyone
within a UK-based organisation who is not themselves a Senior
Person; and
- A bank's board should have a duty to regularly
certify to the regulator that their firm is fulfilling its obligations
under the Senior Persons Regime. (Paragraph 618)
101. Regulators
will need to show judgement and realism in exercising their enhanced
powers. The Commission recommends that the regulators also be
given a power to designate time-limited or remedial responsibilities
that must be assigned to an individual within or thereby brought
within the Senior Persons Regime. (Paragraph 620)
102. It
would be a mistake to prescribe a one-size-fits-all approach to
the assessment of fitness and properness to assume a position
as a Senior Person. What matters more is that the checks are geared
to the responsibilities proposed for the individual and reflect
supervisory judgement by senior regulators with involvement in
the supervision of the bank concerned, rather than a box-ticking
exercise by an isolated unit. The stated intention of regulators
to focus more rigorous pre-approval checks on a smaller number
of key individuals is to be welcomed. (Paragraph 625)
103. The
Commission considers that it would be unduly onerous for both
the regulators and the regulated to make Senior Person status
subject to periodic review. However, the Commission recommends
that the regulators be given clear discretionary powers to review
the assignment of responsibilities to a particular individual
and require the redistribution of certain responsibilities or
the addition of certain conditions. We would expect these powers
to be exercised where, for example, a bank undergoes rapid expansion
or where the regulators have reason to question a bank's approach
to the allocation of responsibilities. We also recommend that
the regulators be able to make approval of an individual Senior
Person subject to conditions, for example where it is felt that
they need to acquire a certain skill to carry out the job well.
It is essential that the regime evolve and adapt over time. It
would be a disaster if it were to relapse back into a one-off
exercise that applied, in practice, only on entry, as with the
Approved Persons Regime. (Paragraph 626)
104. Arrangements
for the allocation of individual responsibilities within banks
will need to take account of changes in personnel. The Commission
recommends that it be a requirement of those in the Senior Persons
Regime that, before relinquishing any responsibilities that are
to be passed to a successor, they prepare a handover certificate
outlining how they have exercised their responsibilities and identifying
the issues relating to their responsibilities of which the next
person holding them should be aware. Such handover certificates
should be held by banks as a matter of record, and should be available
to the regulators both to assess the effectiveness of the Senior
Persons Regime within a particular bank and to assist with the
attribution of responsibility in the event of subsequent enforcement
action. Such a certificate could also serve as an important source
of information in recouping remuneration in accordance with our
proposals in Chapter 8. (Paragraph 627)
The Licensing Regime
105. Regulators'
ability to take enforcement action only against individuals who
are covered by the Approved Persons Regime results in inadequate
coverage, notwithstanding the fact that, in practice, such enforcement
action has seldom been taken. Additionally, requiring that only
this relatively small sub-set of bankers needs to uphold the Statements
of Principle for Approved Persons undermines a wider sense of
responsibility and aspiration to high standards throughout the
banking sector. We have already considered and rejected proposals
to rely solely on a professional standards body and a code of
conduct to address these problems. Instead, the Commission recommends
the establishment of a Licensing Regime alongside the Senior Persons
Regime. Under this a broader set of bank staff would be contractually
obliged to adhere to a set of Banking Standards Rules, which the
regulators could enforce against and which would replace the existing
statements of principle. (Paragraph 632)
106. The
Commission recommends that the Licensing Regime cover anyone working
in banking, including those already within the Senior Persons
Regime, whose actions or behaviour could seriously harm the bank,
its reputation or its customers. It would not need to cover staff
working in auxiliary or purely administrative roles, or those
in junior positions whose autonomy and responsibility is very
limited. Such a scope is likely to include all staff currently
covered by the Approved Persons Regime, including those in customer
dealing functions. (Paragraph 633)
107. Because
the Licensing Regime will be broader in its application than the
Approved Persons Regime it is important that it operate with a
minimum of bureaucratic process. Entry should not require pre-approval
by the regulators, but should require employers to verify the
fitness and propriety of staff, including checking the register
for any record of past disciplinary action. The existing Statements
of Principle for Approved Persons and the accompanying code of
conduct are not intrinsically wrong, but they do not constitute
a sufficiently robust foundation for improving banking standards.
The Commission recommends that regulators develop, after consultation
with banks, staff, unions and those bodies already working on
codes of conduct, a new set of Banking Standards Rules. These
should draw on the existing principles and apply to a wide group
of individuals, forming the foundation of their understanding
for how they are expected to behave: the rules should be written
in a way which is readily meaningful for those who must adhere
to them, unlike the current statements and code which are complex
and heavy with legalistic cross-references to other regulations.
The rules should be generally applicable to all individuals within
the Licensing Regime, rather than sub-divided depending on category
of employee. The rules should explicitly encapsulate expectations
about behaviour which are currently absent from the statements
of principle for individuals, such as treating customers fairly
and managing conflicts of interest and a requirement to draw to
the attention of senior management and regulators conduct which
falls below the standards set out. (Paragraph 634)
108. Banks
should not be able to offload their duties and responsibilities
for monitoring and enforcing individual behaviour on to the regulator
or on to professional bodies. The tools at their disposal have
the potential to be much more usable, effective and proportionate
for the majority of cases than external enforcement, which should
remain the backstop for more serious breaches. (Paragraph 640)
109. The
new licensing duty should not be unduly onerous. Some banks may
already, in practice, have in place much of the control framework
required to implement the Licensing Regime. Banks should already
know the employees whose actions or behaviour could seriously
harm the bank, its reputation or its customers. Banks should also
already monitor their work closely and fully explain to individuals
their contractual responsibilities. Many banks have already acknowledged
that they need to do more in this area, but the incentives for
them to translate this into action are not apparent. (Paragraph
641)
110. The
new Licensing Regime should therefore not only ensure that all
relevant staff are covered by a common set of rules which are
enforceable by the regulators, but should also formalise banks'
responsibilities for ensuring that staff understand and demonstrate
the high standards set out in the regime. This should make clear
banks' primary responsibility for taking disciplinary action under
an employee's contract of employment when standards are breached.
Banks' implementation of the Licensing Regime should be subject
to monitoring by regulators and enforcement action where firms
are found to be failing in their duties. (Paragraph 642)
111. It should be the job of the
bank as employer to inform and instruct each licensed person of
his or her responsibilities and to keep accurate records. Individuals
within the Licensing Regime who are not Senior Persons can nevertheless
have important responsibilities which could have a significant
impact on the bank or its customers. The Commission recommends
that the regulators have the discretionary power to require those
leaving such posts to prepare handover certificates in line with
our earlier recommendation in relation to Senior Persons. Banks
may want to provide training and support to employees to help
them understand how the banking standards rules translate to an
individual's specific role, and reflect the rules in their own
appraisal processes. Professional standards bodies may be able
to play a valuable role in this area. However, the creation and
implementation of such a process should not be held by the regulator
to be a substitute for compliance with the substance of the standards
rules. Most bankers may behave honourably "when no-one is
watching", but some will do so only if there is a genuine
prospect that someone might in fact come looking. Banks need to
maintain and where necessary implement systems that include checks
and random audits, rather than simply addressing standards issues
with process-driven training or when those issues hit the front
pages and threaten the brand. In support of these responsibilities
of the firm, we would expect a Senior Person to be directly responsible
for the performance by a bank of its licensing responsibilities.
(Paragraph 643)
112. This
proposal builds on the ideas put forward by senior bankers for
banks to improve individual standards through self-regulation.
However, the Licensing Regime benefits from robust regulatory
underpinning. This is essential, in view of the shortcomings of
self-regulatory arrangements in financial services in the past.
(Paragraph 644)
113. The
Commission is well aware that neither the Senior Persons Regime
nor the Licensing Regime can resolve the multi-faceted problems
of banking standards. But they can make a contribution. They give
banks an opportunity to demonstrate that they are putting their
houses in order, in a way which could reduce the costly bureaucracy
inherent in the ever more complex reforms of the Approved Persons
Regime currently being considered. They also give regulators more
effective tools to hold individuals to account and, through them,
unambiguous responsibility for ensuring that banks adhere to higher
standards. (Paragraph 645)
Reforming the register
114. It
will be important for the register underpinning the current Approved
Persons Regime to be reformed to take account of the Commission's
recommendations. A single register should cover both the Senior
Persons Regime and the Licensing Regime, although for individuals
covered only by the Licensing Regime it is likely to be more proportionate
only to include their details where there has been enforcement
action against them. Banks should be required to inform regulators
if they take disciplinary action against an employee for reasons
related to a breach of the banking standards rules. In such cases
regulators should assess whether any further sanction is merited.
Regulators should be able to retain such information for their
own purposes even where they decide not to proceed with enforcement
action. The regulators should explore whether information about
disciplinary dismissals could also be communicated to prospective
employers, although the Commission recognises the potential legal
difficulties with such an approach. (Paragraph 651)
115. Sanctions
imposing restrictions on practising can only be effective if they
cannot be circumvented by moving within the industry. Strengthening
the register will address this domestically, but much more should
also be done to move to mutual recognition of sanctions between
jurisdictions. Of particular benefit would be an obligation on
firms to take account of any misdemeanours recorded on the register
in other jurisdictions before hiring staff. The need for such
an obligation between the US and UK is particularly important.
The development of such an obligation, and in particular comprehensive
coverage, may take time. It might ultimately require legislative
change both here and in the US to be effective. The Commission
recommends that the Government and the UK regulators initiate
early discussions with US counterparts on this issue. Subsequent
discussions with the EU and other financial centres may also be
appropriate. (Paragraph 654)
Banking as a special case
116. The
authorities must not be constrained, in implementing the proposed
reforms relating to individuals, by the fact that the existing
Approved Persons Regime and register apply to the whole financial
services sector rather than just banks. Events have demonstrated
why reforms are urgently needed to promote improved individual
standards in banking. There may be a strong case for applying
some of these reforms to other areas of the financial services
sector and it is plausible to suppose that the deficiencies of
the Approved Persons Regime are replicated beyond banking. However,
not only does analysis of this issue lie outside the scope of
the Commission's work, but there is a risk that an extension of
reform would delay the timetable for reforms, both due to the
wider interests involved and the operational flaws of the current
Approved Persons Regime. We therefore recommend that the arrangements
for a Senior Persons Regime, for a Licensing Regime and for a
register, reflecting the operation of these regimes, be put in
place in the first instance separately from the Approved Persons
Regime, which should cease to apply to banking. It is for the
regulators to advise on the merits of the new schemes' wider applicability.
(Paragraph 656)
Chapter 7: Bank governance, standards and culture
Shareholders: the silent owners
117. Institutional
shareholders have unlimited upside to their investment, but a
downside limited to their equity stake. Shareholders also fund
only a tiny proportion of a bank's balance sheet, which can incentivise
them to encourage banks to increase short-term risks. In the run-up
to the financial crisis, shareholders failed to control risk-taking
in banks, and indeed were criticising some for excessive conservatism.
Some bank leaderships resisted this pressure, but others did not.
The Independent Commission on Banking believed that its proposed
ring-fence would create incentives for shareholders to be more
mindful of excessive risk. However, we agree with the Kay Review
that incentives for institutional investors to engage with companies
remain weak. The primary responsibility of institutional investors
is to earn returns for their clients, with engagement with company
managements only likely to be undertaken by firms that regard
it as contributing to that responsibility. The nature of the asset
management industry and the financial incentives for key decision-makers
in that industry incentivise focus on short-term investment performance,
rather than engagement to promote the longer term success of companies,
even though the latter may be better aligned with the long-term
interests of the ultimate beneficial owners of the shares. Even
the largest investors own relatively small holdings in large companies
such as banks, limiting their influence. The misalignment between
the incentives of asset manager and the long-term interests of
a company, coupled with the fact that shareholders contribute
only a tiny sliver of a bank's balance sheet, mean it would be
a mistake to expect greater empowerment and engagement of shareholders
to lead to the exercise of profound and positive influence on
the governance of banks. (Paragraph 666)
118. The
financial crisis has underlined, if this were needed, the importance
of effective scrutiny and the exercise of discipline by creditors
to the maintenance of banking standards. Such discipline has been
lacking, in large part as a result of the perceived taxpayer guarantee.
The measures to bear down on the guarantee, which the Commission
has already noted should be a priority, would be the most effective
way of correcting this, as bondholders, broadly defined, would
have a greater incentive properly to assess credit risk. Market
discipline from creditors subject to the potential of bail-in
should encourage banks and their managements better to balance
downside and upside risks. The Commission endorses the good practice
adopted by an increasing number of banks of publicly disclosing,
and making widely available, the contents of their presentations
to bondholders. The Commission encourages bondholders, where they
are sufficiently concerned, to raise such issues publicly where
practical. The PRA should examine the scope for extending bondholder
influence of this type. (Paragraph 674)
Bank boards and governance
119. Both
the financial crisis and conduct failures have exposed very serious
flaws in the system of board oversight of bank executives and
senior management. The corporate governance of large banks was
characterised by the creation of Potemkin villages to give the
appearance of effective control and oversight, without the reality.
In particular, many non-executive directorsin many cases
experienced, eminent and highly-regarded individualsfailed
to act as an effective check on, and challenge to, executive managers.
Our work on HBOS provided considerable evidence of this failure.
(Paragraph 684)
120. Failures
of board governance have taken place in firms with very different
models of corporate governance, in banks with two-tier boards
as well as those with unitary boards, and in banks whose boards,
whether of the US or UK type, differ significantly both in terms
of size, composition and the amount of time non-executives devote
to their roles. Banks whose board-level governance arrangements
could be described on paper as approximating to best practice
have run into serious governance problems. There were frequently
several common elements to bank governance failures. Some CEOs
were overly dominant, which the Board as a whole failed to control.
Chairmen proved weak; often they were too close to, and became
cheerleaders for, the CEO. NEDs provided insufficient scrutiny
of, or challenge to, the executive, and were too often advocates
for expansion rather than cautioning of the risks involved. There
was insufficient wider banking experience among NEDs and the resources
available to them were inadequate. Central functions, including
risk and control, had insufficient capability and status to perform
their functions and were often regarded as an impediment to the
business, rather than essential to its long-term success. (Paragraph
703)
121. Proponents
of corporate governance solutions can be prone to overestimate
the benefit that their particular favoured measure will provide.
Structural or procedural changes to bank boards would not have
prevented the last crisis and will not prevent the next one. Nevertheless,
the Commission has a number of proposals which, taken together,
we believe will help to bring about a desirable change in the
culture and overall approach of boards. (Paragraph 705)
122. The
Commission recommends that the Financial Reporting Council publish
proposals, within six months of the publication of this Report,
designed to address the widespread perception that some 'natural
challengers' are sifted out by the nomination process. The nomination
process greatly influences the behaviour of non-executive directors
and their board careers. Fundamental reform may be needed. The
Commission considers that the Financial Reporting Council should
examine whether a Nomination Committee should be chaired by the
Chairman of a bank or by the Senior Independent Director. (Paragraph
706)
123. There
is a danger that the non-executives directors of banks are self-selecting
and self-perpetuating. In the interests of transparency, and to
ensure that they remain as independent as possible, the Commission
recommends that the regulators examine the merits of requiring
each non-executive vacancy on the board of a bank above the ring-fence
threshold to be publicly advertised. (Paragraph 707)
124. The
obligations of directors to shareholders in accordance with the
provisions of the Companies Act 2006 create a particular tension
between duties to shareholders and financial safety and soundness
in the case of banks. For as long as that tension persists, it
is important that it be acknowledged and reflected in the UK Corporate
Governance Code, in the PRA's Principles of Business and under
the Senior Persons Regime. The Commission has several recommendations
in the light of this, which should at the very least apply to
banks above the ring-fence threshold.
- The Commission recommends that the UK Corporate
Governance Code be amended to require directors of banks to attach
the utmost importance to the safety and soundness of the firm
and for the duties they owe to customers, taxpayers and others
in interpreting their duties as directors;
- The Commission recommends that the PRA Principles
for Businesses be amended to include a requirement that a bank
must operate in accordance with the safety and soundness of the
firm and that directors' responsibilities to shareholders are
to be interpreted in the light of this requirement;
- The Commission recommends that the responsibilities
of Senior Persons who are directors include responsibilities to
have proper regard to the safety and soundness of the firm; and
- The Commission recommends that the Government
consult on a proposal to amend section 172 of the Companies Act
2006 to remove shareholder primacy in respect of banks, requiring
directors of banks to ensure the financial safety and soundness
of the company ahead of the interests of its members. (Paragraph
708)
125. The
importance of the Chairman's role should be reflected in the post's
responsibilities under the proposed Senior Persons Regime. Chairmen
should have specific overall responsibility for leadership of
the board as well for ensuring, monitoring and assessing its effectiveness.
This should include a responsibility for promoting an open exchange
of views, challenge and debate and ensuring that other non-executives
have the tools, resources and information to carry out their roles
effectively, particularly their challenge function. It should
be the duty of the Chairman to hold annual meetings with the chairmen
of every board sub-committee separate from any attendance at meetings
to ensure that he or she has an overview of the subject area within
those sub-committees' responsibility. Bank Chairmen should in
future have an explicit responsibility for setting standards and
providing effective oversight over how they are embedded through
the organisation. In addition, it is essential the Chairman has
a responsibility to ensure that he or she, together with his or
her office, provides a genuine check and balance to the executives.
(Paragraph 712)
126. We
have received no evidence that a two-thirds time commitment has
led chairmen of major banks to 'go native', and believe that the
risk of this occurring with a full-time Chairman may have been
overstated. In any case, the risks of partial disengagement are
likely to be greater. The accountability and personal responsibility
of Chairmen will be enhanced if they are engaged on a near full-time
basis. In light of the crucial role played by the Chairman of
a major financial institution, the Commission recommends that
a full-time Chairman should be the norm. The implication of our
proposals is that the Chairman of a large bank should usually
not hold any other large commercial non-executive, let alone executive,
positions. (Paragraph 715)
127. The
Commission recommends that the Senior Independent Director should,
under the proposed Senior Persons Regime, have specific responsibility
for assessing annually the performance of the Chairman of the
board and, as part of this, for ensuring that the relationship
between the CEO and the Chairman does not become too close and
that the Chairman performs his or her leadership and challenge
role. We would expect the regulator to maintain a dialogue with
the Senior Independent Director on the performance of the Chairman:
the Senior Independent Director should meet the PRA and FCA each
year to explain how the Senior Independent Director has satisfied
himself or herself that the Chairman has held the CEO to account,
encouraged meaningful challenge from other independent directors
and maintained independence in leading the board. (Paragraph 717)
128. Non-executive
directors in systemically important financial institutions have
a particular duty to take a more active role in challenging the
risks that businesses are running and the ways that they are being
managed. The FSA's report into the failure of RBS demonstrated
that this was often not the case in the past. For non-executive
directors to be more effective, they may need to make more use
of their current powers under the UK Corporate Governance Code
to obtain information and professional advice, both internally
and externally. In this context, it is essential that the office
of the chairman is well-resourced to enable it to provide independent
research and support to the non-executive directors. (Paragraph
720)
Internal controls and disciplines
129. Each
bank board should have a separate risk committee chaired by a
non-executive director who possesses the banking industry knowledge
and strength of character to challenge the executive effectively.
The risk committee should be supported by a strong risk function,
led by a chief risk officer, with authority over the separate
business units. Boards must protect the independence of the Chief
Risk Officer, and personal responsibility for this should lie
with the chairman of the risk committee. The Chief Risk Officer
should not be able to be dismissed or sanctioned without the agreement
of the non-executive directors, and his or her remuneration should
reflect this requirement for independence. The Chief Risk Officer
should be covered by the Senior Persons Regime, and the responsibilities
assigned to the holder of that post should make clear that the
holder must maintain a voice that is independent of the executive.
(Paragraph 729)
130. It
is important that banks have clear lines of accountability for
the assurance of overall regulatory compliance. A blurring of
responsibility between the front line and compliance staff risks
absolving the front line from responsibility for risk. Compliance
involvement in product development can make it more difficult
for compliance staff subsequently to perform their independent
control duties. Their involvement needs careful handling. Responsibility
for acting in accordance with the letter and spirit of regulation
should lie with every individual in a bank. This responsibility
should not be outsourced to a compliance function, any more than
to the regulator itself, particularly in the light of the fact
that, owing to the complexity of banks, the compliance function
would face a very difficult task were this responsibility to lie
solely with it. (Paragraph 735)
131. The
Commission notes with approval measures taken by banks to involve
control functions in the performance assessment of senior and
front-line staff. There is a strong case for extending this further.
To have a strong impact on behaviour, clarity in how such mechanisms
operate is desirable. The involvement of the front-line in assessing
second-line performance threatens to further undermine the independence
of the second line. This effect can be exacerbated by ingrained
status differences between staff in different functions. (Paragraph
736)
132. We
do not wish to be prescriptive about the role of the Head of Compliance.
We see parallels with the role of the Chief Risk Officer, insofar
as protecting the independence of the Head of Compliance role
is paramount. This should be a particular responsibility of a
named individual non-executive director. The Commission recommends,
as with the Chief Risk Officer, that dismissal or sanctions against
the Head of Compliance should only follow agreement by the non-executive
directors. Such an action would, under existing arrangements,
also need to be disclosed to the regulator. (Paragraph 737)
133. Internal
audit's independence is as important as that of the Chief Risk
Officer and the Head of Group Compliance, and its preservation
should similarly be the responsibility of a named individual non-executive
director, usually the chairman of the audit committee. Dismissal
or sanctions against the head of internal audit should also require
the agreement of the non-executive directors. (Paragraph 741)
134. The
"three lines of defence" have not prevented banks' control
frameworks failing in the past in part because the lines were
blurred and the status of the front-line, remunerated for revenue
generation, was dominant over the compliance, risk and audit apparatus.
Mere organisational change is very unlikely, on its own, to ensure
success in future. Our recommendations provide for these lines
to be separate, with distinct authority given to internal control
and give particular non-executive directors individual personal
responsibility for protecting the independence of those responsible
for key internal controls. This needs to be buttressed with rigorous
scrutiny by the new regulators of the adequacy of firms' control
frameworks. (Paragraph 742)
Standards and culture
135. Profound
cultural change in institutions as large and complex as the main
UK banks is unlikely to be achieved quickly. Bank leaders will
need to commit themselves to working hard at the unglamorous task
of implementing such change for many years to come. (Paragraph
748)
136. Poor
standards in banking are not the consequence of absent or deficient
company value statements. Nor are they the result of the inadequate
deployment of the latest management jargon to promulgate concepts
of shared values. They are, at least in part, a reflection of
the flagrant disregard for the numerous sensible codes that already
existed. Corporate statements of values can play a useful role
in communicating reformist intent and supplementing our more fundamental
measures to address problems of standards and culture. But they
should not be confused with solutions to those problems. (Paragraph
754)
137. The
appropriate tone and standard of behaviour at the top of a bank
is a necessary condition for sustained improvements in standards
and culture. However, it is far from sufficient. Improving standards
and culture of major institutions, and sustaining the improvements,
is a task for the long term. For lasting change, the tone in the
middle and at the bottom are also important. Unless measures are
taken to ensure that the intentions of those at the top are reflected
in behaviour at all employee levels, fine words from the post-crisis
new guard will do little to alter the fundamental nature of the
organisations they run. There are some signs that the leaderships
of the banks are moving in the right direction. The danger is
that admirable intentions, a more considered approach, and some
early improvements, driven by those now in charge, are mistaken
for lasting change throughout the organisation. (Paragraph 762)
138. We
believe that the influence of a professional body for banking
could assist the development of the culture within the industry
by introducing non-financial incentives, which nonetheless have
financial implications, such as peer pressure and the potential
to shame and discipline miscreants. Such a body could, by its
very existence, be a major force for cultural change and we have
already recommended that its establishment should be pursued as
a medium to long term goal alongside other measures such as new
regulatory provisions. (Paragraph 763)
139. There
is little point in senior executives talking about the importance
of the customer and then putting in place incentive and performance
management schemes which focus on sales which are not in the interests
of the customer. As long as the incentives to break codes of conduct
exceed those to comply, codes are likely to be broken. Where that
gap is widest, such as on trading floors, codes of conduct have
gained least traction. This betrays a wider problem with stand-alone
programmes to raise standards and improve culture. Attempts to
fix them independently of the causes are well-intentioned and
superficially attractive, but are likely to fail. (Paragraph 768)
140. The
culture on the trading floor is overwhelmingly male. The Government
has taken a view on having more women in the boardroom through
the review carried out by Lord Davies of Abersoch and his recommendations
that FTSE 100 companies increase the number of women directors
who serve on their boards. If that is beneficial in the boardroom
so it should be on the trading floor. The people who work in an
industry have an impact on the culture of that industry. More
women on the trading floor would be beneficial for banks. The
main UK-based banks should publish the gender breakdown of their
trading operations and, where there is a significant imbalance,
what they are going to do to address the issue within six months
of the publication of this Report and thereafter in their annual
reports. (Paragraph 769)
141. In
order for banks to demonstrate to the public that they have changed
their standards and culture, they will need to provide clear evidence
of such change. Banks are well aware of their past failings. They
should acknowledge them. Further opportunity to demonstrate change
is offered by ongoing concerns, such as approaches taken to customer
redress or involvement in activities inconsistent with a customer
service ethos. The clearest demonstration of change will come
with the avoidance of further standards failings of the sort that
led to the creation of the Commission. (Paragraph 770)
Driving out fear
142. The
Commission was shocked by the evidence it heard that so many people
turned a blind eye to misbehaviour and failed to report it. Institutions
must ensure that their staff have a clear understanding of their
duty to report an instance of wrongdoing, or 'whistleblow', within
the firm. This should include clear information for staff on what
to do. Employee contracts and codes of conduct should include
clear references to the duty to whistleblow and the circumstances
in which they would be expected to do so. (Paragraph 784)
143. In
addition to procedures for formal whistleblowing, banks must have
in place mechanisms for employees to raise concerns when they
feel discomfort about products or practices, even where they are
not making a specific allegation of wrongdoing. It is in the long-term
interest of banks to have mechanisms in place for ensuring that
any accumulation of concerns in a particular area is acted on.
Accountability for ensuring such safeguards are in place should
rest with the non-executive director responsible for whistleblowing.
(Paragraph 786)
144. A
non-executive board memberpreferably the Chairmanshould
be given specific responsibility under the Senior Persons Regime
for the effective operation of the firm's whistleblowing regime.
That Board member must be satisfied that there are robust and
effective whistleblowing procedures in place and that complaints
are dealt with and escalated appropriately. It should be his or
her personal responsibility to see that they are. This reporting
framework should provide greater confidence that wider problems,
as well as individual complaints, will be appropriately identified
and handled. (Paragraph 788)
145. The
Commission recommends that the Board member responsible for the
institution's whistleblowing procedures be held personally accountable
for protecting whistleblowers against detrimental treatment. It
will be for each firm to decide how to operate this protection
in practice, but, by way of example, the Board member might be
required to approve significant employment decisions relating
to the whistleblower (such as changes to remuneration, change
of role, career progression, disciplinary action), and to satisfy
him or herself that the decisions made do not constitute detrimental
treatment as a result of whistleblowing. Should a whistleblower
later allege detrimental treatment to the regulator, it will be
for that Board member to satisfy the regulator that the firm acted
appropriately. (Paragraph 791)
146. Whistleblowing
reports should be subjected to an internal 'filter' by the bank
to identify those which should be treated as grievances. Banks
should be given an opportunity to conduct and resolve their own
investigations of substantive whistleblowing allegations. We note
claims that 'whistleblowing' being treated as individual grievances
could discourage legitimate concerns from being raised. (Paragraph
792)
147. The
regulator should periodically examine a firm's whistleblowing
records, both in order to inform itself about possible matters
of concern, and to ensure that firms are treating whistleblowers'
concerns appropriately. The regulators should determine the information
that banks should report on whistleblowing within their organisation
in their annual report. (Paragraph 793)
148. All
Senior Persons should have an explicit duty to be open with the
regulators, not least in cases where the Senior Person becomes
aware of possible wrongdoing, regardless of whether the Senior
Person in question has a direct responsibility for interacting
with the regulators. (Paragraph 796)
149. The
FCA's evidence appeared to show little appreciation of the personal
dilemma that whistleblowers may face. The FCA should regard it
as its responsibility to support whistleblowers. It should also
provide feedback to the whistleblower about how the regulator
has investigated their concerns and the ultimate conclusion it
reached as to whether or not to take enforcement action against
the firm and the reasons for its decision. The Commission recommends
that the regulator require banks to inform it of any employment
tribunal cases brought by employees relying on the Public Interest
Disclosure Act where the tribunal finds in the employee's favour.
The regulator can then consider whether to take enforcement action
against individuals or firms who are found to have acted in a
manner inconsistent with regulatory requirements set out in the
regulator's handbook. In such investigations the onus should be
on the individuals concerned, and the non-executive director responsible
within a firm for protecting whistleblowers from detriment, to
show that they have acted appropriately. (Paragraph 799)
150. We
note the regulator's disquiet about the prospect of financially
incentivising whistleblowing. The Commission calls on the regulator
to undertake research into the impact of financial incentives
in the US in encouraging whistleblowing, exposing wrongdoing and
promoting integrity and transparency in financial markets. (Paragraph
803)
151. We
have said earlier in this Report that the financial sector must
undergo a significant shift in cultural attitudes towards whistleblowing,
from it being viewed with distrust and hostility to one being
recognised as an essential element of an effective compliance
and audit regime. Attention should focus on achieving this shift
of attitude. (Paragraph 804)
152. A
poorly designed whistleblowing regime could be disruptive for
a firm but well designed schemes can be a valuable addition to
its internal controls. The regulator should be empowered in cases
where as a result of an enforcement action it is satisfied that
a whistleblower has not been properly treated by a firm, to require
firms to provide a compensatory payment for that treatment without
the person concerned having to go to an employment tribunal. (Paragraph
805)
Chapter 8: Remuneration
Rewards out of kilter
153. Remuneration
lies at the heart of some of banks' biggest problems. Risk and
reward are misaligned, incentivising poor behaviour. The core
function of banks should be to manage and price the risk inherent
in the taking of loans and deposits and in holding other financial
products over different time periods. One effect of limited liability
is to enable individuals to extract high rewards predicated on
disproportionate risks, sheltered from exposure to commensurate
potential losses. This misalignment has been further reinforced
by the implicit taxpayer guarantee and by the practice of making
pay awards over a relatively short period. This has included remuneration
for the creation and marketing of products, to retail and wholesale
customers, for which the full costs and benefits may not be clear
for many years. The risk inherent in complex derivatives is particularly
hard to assess. (Paragraph 836)
154. Aggregate
remuneration continues to consume a high share of returns relative
to shareholder dividends and capital. From this share, a relatively
small proportion of senior management and supposedly irreplaceable
key staff have received very large rewards. Banks should be free
to compete in the global market: the use of remuneration to retain
the most productive staff is a legitimate management tool. However,
the financial crisis and its aftermath have exposed the extent
to which many of the highest rewards were unjustified. Senior
bankers have also benefited from a remuneration consultancy industry
whose advice may itself have been distorted by conflicts of interest
and by board Remuneration Committees trapped into ever higher
awards by allegiance to colleagues and the ratchet effect of industry
competitors. A culture of entitlement to high pay developed which
has yet fully to be dispelled. (Paragraph 837)
155. Over
time, increased capital ratios, lower levels of leverage and structural
changes to reduce the scale of the implicit taxpayer guarantee
through ring-fencing will help to redress the misaligned incentives.
However, these measures will not address all the problems that
remain. Further public policy intervention is required. (Paragraph
838)
156. The
purpose of the Commission's proposals is, as far as possible,
to address the misalignment of risk and reward, and in doing so,
reduce the extent to which remuneration increases the likelihood
of misconduct and of taxpayer bailout. The Commission's intention
is not to prevent rewards when merited-and still less to exert
retribution on a group or industry-but to ensure that the rewards
of banking flow only in accordance with the full long-term costs
and benefits of the risks taken. (Paragraph 839)
Fixed and variable remuneration
157. The
scale and forms of variable remuneration as they have been paid
to staff at senior levels in banks, and investment banking in
particular, have encouraged the pursuit of high risks for short-term
gain, at times seemingly heedless of the long-term effects. The
high levels of variable remuneration that persisted in the sector
even after 2008 are difficult to justify. (Paragraph 850)
158. There
are distinct advantages to a significant proportion of banking
remuneration being in variable rather than fixed form. It is easier
to adjust variable remuneration to reflect the health of an individual
bank. The use of variable remuneration also allows for deferral
and the recouping of rewards in ways which better align remuneration
with the longer term interests of a bank. There are signs already
that the fall in bonuses in recent years has been offset by an
increase in fixed remuneration. We note that Andrew Bailey considered
that the EU bonus cap would "push up fixed remuneration"
rather than act to reduce overall pay. We are not convinced that
a crude bonus cap is the right instrument for controlling pay,
but we have concluded that variable remuneration needs reform.
(Paragraph 851)
Yardsticks for variable remuneration
159. Many
of the so-called profits reported by banks in the boom years turned
to dust when markets went into reverse. However, for some individual
bankers, they had served their purpose, having been used in calculations
leading to huge bonuses which could not be recouped. The means
by which profits are calculated for remuneration purposes needs
to change, even if there is no change in the accounting standards
which underpin reported profits and losses. Unless they change,
incentive structures will continue to encourage imprudent banking.
In Chapter 9 we consider the case for the introduction of regulatory
accounts. Alongside any change in this area, the Commission recommends
that regulators set out, within the new Remuneration Code, criteria
for the determination of profits for remuneration purposes, at
company level and from business units. We would expect that unrealised
profits from thinly traded or illiquid markets would usually not
be appropriate for this purpose. (Paragraph 861)
160. Banks
and regulators should avoid relying unquestioningly on narrow
measures of bank profitability in setting remuneration. One measure
which has commonly been usedreturn on equitycreates
perverse incentives, including the incentive to use debt rather
than equity to finance bank activity, thus increasing leverage.
Using return on assets as an alternative measure would remove
the incentive towards leverage, but carries its own problems,
including an incentive to hold riskier assets. While a measure
based on risk-weighted return could help address this, we have
noted the severe limitations of risk-weighting in the context
of the Basel II and Basel III framework. (Paragraph 862)
161. The
Commission recommends that bank remuneration committees disclose,
in the annual report, the range of measures used to determine
remuneration, including an explanation of how measures of risk
have been taken into account and how these have affected remuneration.
The regulators should assess whether banks are striking an appropriate
balance between risk and reward. They should be particularly sceptical
about reliance on return on equity in calculating remuneration.
The regulators should also assess whether the financial measures
that are used cover adequately the performance of the entire bank
as well as specific business areas. The former serves to create
a collective interest in the long-term success of the institution.
Where it is not satisfied, the regulator may need to intervene.
It is for banks to set remuneration levels, but it is for regulators
to ensure that the costs and benefits of risks in the long term
are properly aligned with remuneration. This is what judgement-based
regulation should mean. (Paragraph 863)
162. Misaligned
remuneration incentives have also contributed to conduct failure,
including scandals such as PPI. The Commission welcomes announcements
by some banks that retail staff will no longer be rewarded based
on their sales, but notes the widespread warnings that sales-based
rewards may persist informally even where their explicit inclusion
in incentive schemes is removed. The Commission recommends that
the new Remuneration Code include a provision to limit the use
and scale of sales-based incentives at individual or business
unit level, and for the regulator to have the ability to limit
or even prohibit such incentives. (Paragraph 864)
Reforming variable remuneration
163. Variable
remuneration does not form a large proportion of total pay for
the vast majority of bank staff. However, the use of very high
bonuses, both in absolute terms and relative to salaries, is more
prevalent in banking than in other sectors. As we have already
noted, there are advantages to variable rather than fixed remuneration,
but it is essential that the use of variable remuneration is far
better aligned with the longer term interests of the bank. The
Commission's proposals which follow do not relate simply to investment
bankers or directors, but should apply to all those whose actions
or behaviour could seriously harm the bank, its reputation or
its customers. They should apply not only to all Senior Persons
but also to all licensed staff receiving variable remuneration
in accordance with the proposals in Chapter 6. (Paragraph 877)
164. The
remuneration of senior bankers has tended to suffer from the fundamental
flaw that annual rewards were not sufficiently aligned with the
long-term interests of the firm. Bankers often had something akin
to "skin in the game" through payment of part of bonuses
and long term incentive plans in equity. But this provided unlimited
upside but with the limited liability that comes with equity putting
a floor under the downside. The Commission recommends that there
should be a presumption that all executive staff to whom the new
Remuneration Code applies receive variable remuneration and that
a significant proportion of their variable remuneration be in
deferred form and deferred for longer than has been customary
to date. In some cases, there is a danger that individuals will
be penalised for the poor performance of their colleagues or successors.
However, such concerns are outweighed by the advantages of ensuring
that these staff have a bigger personal interest in, and responsibility
for, the long-term future of the bank. This will change behaviour
for the better. It is particularly important for some of the team-based
functions where members have often felt a greater loyalty to the
small team than to the wider bank interest. By linking rewards
much more closely to long term risks, deferral can recreate some
of the features of remuneration structures characteristic of unlimited
liability partnerships. (Paragraph 878)
165. For
the most senior and highest rewarded it is even more crucial that
their remuneration reflects the higher degree of individual responsibility
expected of them. Flexibility on the part of firms, and judgement
on the part of regulators, is essential to take account of wide
variations of risk and time horizons of its maturity in different
areas of banking. Poorly designed schemes may increase the risk
of gaming or circumvention of regulations and will have adverse
or perverse affects on behaviour. (Paragraph 879)
166. Too
high a proportion of variable remuneration in the banking sector
is often paid in the form of equity or instruments related to
future prospects for equity in the bank concerned. The path of
share prices after remuneration has been awarded is unlikely to
reflect accurately the quality of decisions made and actions taken
in the period to which the award relates. Too much reliance on
equity value creates perverse incentives for leverage and for
short-termism. There are merits in the greater use of instruments
such as bail-in bonds in deferred compensation. If senior staff
are liable to lose their deferred pay if the bank goes bust, it
will concentrate minds. In the event of capital inadequacy, such
instruments would convert into capital available to absorb losses.
However, there is no package of instruments which necessarily
best matches risks and rewards in each case. Flexibility in the
choice of instruments is vital. Banks should make this choice,
dependent on particular circumstances. It is equally important
that the supervisor assesses whether these choices are consistent
with the appropriate balance of risks and rewards. (Paragraph
880)
167. The
ability to defer a proportion of an individual's bonus is an important
feature of remuneration schemes for those in senior decision-making
and risk-taking roles in banks. This is because bonuses are typically
awarded annually, while profits or losses from banking transactions
may not be realised for many years. Similarly, misconduct may
be identified only some time after the misbehaviour has occurred.
Deferral for two or three years is likely to be insufficient to
take account of the timescale over which many problems come home
to roost in banking, whether in the form of high risk assets turning
bad or misconduct at individual or wider level coming to light.
Deferral should be over a longer period than currently is the
case. However, no single longer period is appropriate and flexibility
in approach is required to align risk and rewards. This is the
job of the bank, but the supervisor should monitor decisions closely,
particularly where the individuals concerned pose the greatest
potential risks. The Commission recommends that the new Remuneration
Code include a new power for the regulators to require that a
substantial part of remuneration be deferred for up to 10 years,
where it is necessary for effective long-term risk management.
(Paragraph 881)
168. The
deferral of variable remuneration for longer periods is so important
because it allows that remuneration to be recouped in appropriate
circumstances. Clawback or similar recovery is also an appropriate
course of action in cases where fines are levied on the firm,
such as for misconduct in relation to LIBOR. However, what matters
more is the development of legal and contractual arrangements
whereby deferred remuneration comes to be seen as contingent,
so that it can be recouped in a wider range of circumstances.
These might include not only enforcement action, but also a fall
in bank profitability resulting from acts of omission or commission
in the period for which the variable remuneration was initially
paid. (Paragraph 882)
169. In
the most egregious cases of misconduct, recovery of vested remuneration
may be justified. The Commission recommends that the regulator
examines whether there is merit in further powers, in the cases
of individuals who have been the subject of successful enforcement
action, to recover remuneration received or awarded in the period
to which the enforcement action applied. (Paragraph 883)
170. One
of the fundamental weaknesses of bank remuneration in recent years
has been that it lacked down-side incentives in the worst case
scenarios that were remotely comparable to the upside incentives
when things seemed to be going well. This disparity was laid bare
by taxpayers bailing out failed banks while those responsible
for failure continued to enjoy the fruits of their excess. We
believe that the alignment of the financial interests of the
most crucial bank staff with those of the bank is an important
factor in addressing this imbalance. The Commission recommends
accordingly that legislation be introduced to provide that, in
the event that a bank is in receipt of direct taxpayer support
in the form of new capital provision or new equity support, or
a guarantee resulting in a contingent liability being placed on
to the public sector balance sheet, the regulators should have
an explicit discretionary power to render void or cancel all deferred
compensation, all entitlements for payments for loss of office
or change of control and all unvested pension rights in respect
of Senior Persons and other licensed staff. (Paragraph 884)
171. Our
recommendations in this section are aimed at incentivising bank
management and staff to prioritise appropriate conduct, and the
safety and soundness of their organisation, by enabling some or
all of the deferred remuneration to be recouped in the event of
conduct or prudential failures emerging. Such deferral structures
as the industry had prior to the financial crisis were intended
as staff retention schemes, rather than to incentivise appropriate
behaviour. Consequently, these awards are generally forfeited
if an employee resigns from the firm during the vesting period.
As a result, it is common practice for banks hiring staff from
competitors to compensate recruits for the value they have forfeited,
by awarding them equivalent rights in their own deferred compensation
scheme. This is tantamount to wiping the slate clean and, if it
continued, would blunt the intended effect of our recommendations.
International agreement on this issue, while desirable, is unlikely.
The Commission recommends that the regulators come forward with
proposals for domestic reform in this area as a matter of urgency.
Among possible proposals, they should consider whether banks could
be required to leave in place any deferred compensation due to
an individual when they leave the firm. The regulators should
also examine the merits of a new discretionary regulatory power,
in cases where a former employee would have suffered deductions
from deferred remuneration, but does not do so as a result of
having moved to another bank, to recover from the new employer
the amount that would have been deducted. This would be on the
understanding that the cost is likely to be passed on to the employee.
The use of this power might be initiated by the former employer,
or by the regulator, in specific instances such as company fines
for misconduct. (Paragraph 885)
172. The
adoption of the proposals set out in this section would amount
to a substantial realignment of the risks and rewards facing senior
bankers. Even with legislative backing and Parliamentary support,
there are considerable obstacles to their rapid and successful
implementation. This area is subject to considerable international
regulatory interest and there is a danger that further interventions
could change the wider framework within which our recommendations
would operate. The regulators should ensure that new employment
contracts are consistent with effective deferral schemes and should
be aware of the potential for gaming over-prescriptive rules,
or encouraging the arbitrage of entitlements. In fulfilling these
roles, the regulators should exercise judgement in determining
whether banks are operating within the spirit of the Commission's
recommendations as implemented. (Paragraph 886)
Board remuneration
173. The
Commission regards it as inappropriate for non-executives to receive
some of their compensation in the form of shares or other instruments
the aggregate amount of which could be influenced by leverage.
A bank board should act as a bulwark against excessive risk-taking
driven by individual rewards. The challenge and scrutiny responsibilities
of non-executive directors are not consistent with the pursuit
of additional awards based on financial performance. The Commission
recommends that the new Remuneration Code prohibit variable, performance-related
remuneration of non-executive directors of banks. (Paragraph
890)
The international dimension
174. Remuneration
requirements should, ideally, be mandated internationally in order
to reduce arbitrage. The Commission expects the UK authorities
to strive to secure international agreement on changes which are
focused on the deferral, conditionality and form of variable remuneration,
and the measures for its determination, rather than simply the
quantitative relationship to fixed remuneration, because it is
changes of this kind that will most improve the behaviour of bankers
in the longer term. In particular, we expect the Government and
the Bank of England to ensure that the technical standards under
CRD IV contain sufficient flexibility for national regulators
to impose requirements in relation to instruments in which deferred
bonuses can be paid which are compatible with our recommendations.
(Paragraph 896)
175. It
must be recognised, however, that international agreement on some
of the changes we envisage may be neither fast not complete. This
may lead some to advance the argument that the UK will be placed
at a competitive disadvantage. The extent to which this is true
has been overstated. The UK has great strengths as a financial
centre, but, partly because of those strengths, it also faces
substantial risks. The PRA must adopt a common sense and flexible
approach to handling these issues. However, its overriding objective
of financial stability should not be compromised and, in fulfilling
this objective, the risk of an exodus should be disregarded.
(Paragraph 897)
Getting it done
176. The
current terms of the Remuneration Code do not provide a clear
basis for full implementation of our proposals. The Commission
recommends that a new Remuneration Code be introduced on the basis
of a new statutory provision, which should provide expressly for
the regulators to prescribe such measures in the new Code as they
consider necessary to secure their regulatory objectives. (Paragraph
899)
177. Our
recommendations place undue additional burdens on neither banks
nor regulators. The proposals require banks to identify which
staff are associated with high prudential or conduct risks and
assess how the structures and timings of incentive schemes may
affect the behaviour of employees. This should be tantamount to
routine risk management in a well-run bank and banks should already
be doing it as part of their internal controls. The regulator
will need to check that the bank has identified the key risk-takers
and decision-makers and confirm that deferred rewards will flow
only when the full, long-term consequences of their decisions
have become evident. The proposals require the careful examination
of the remuneration of the highest risk Senior Persons Regime
staff and spot checks on other licensed employees. Incentives
are fundamental to the behaviour of individual bankers. Regulators
should already be undertaking these checks. (Paragraph 900)
178. There
is a risk that increased regulatory oversight could lead to banks
outsourcing their remuneration policies to the PRA, in the same
way they outsourced risk management before the financial crisis.
However, we anticipate that other changes will, over time, have
the effect of imposing more effective market discipline on remuneration.
The PRA should monitor remuneration carefully and report on it
as part of the regular reporting of its activities. (Paragraph
905)
179. The
Commission recommends that banks' statutory remuneration reports
be required to include a disclosure of expected levels of remuneration
in the coming year by division, assuming a central planning scenario
and, in the following year, the differences from the expected
levels of remuneration and the reasons for those differences.
The disclosure should include all elements of compensation and
the methodology underlying the decisions on remuneration. The
individual remuneration packages for executive directors and all
those above a threshold determined by the regulator should normally
be disclosed, unless the supervisor has been satisfied that there
is a good reason for not doing so. The Commission further recommends
that the remuneration report should be required to include a summary
of the risk factors that were taken into account in reaching decisions
and how these have changed since the last report. (Paragraph 906)
180. We
do not recommend the setting of levels of remuneration by Government
or regulatory authorities. However, banks should understand that
many consider the levels of reward in recent years to have grown
to grotesque levels at the most senior ranks and that such reward
often bears little relation to any special talent shown. This
also needs to be seen in the context of the fact that many people
have seen little or no increase in pay over the same period. We
would encourage shareholders to take a more active interest in
levels of senior remuneration. Individual rewards should be primarily
a matter for banks and their owners. Nonetheless, we recognise
that the measures we propose will radically alter the structure
of bank remuneration. They will also provide far greater information
to shareholders in carrying out their role. (Paragraph 908)
Chapter 9: Regulatory and supervisory approach
Regulatory failure
181. The
primary responsibility for banking standards failures must lie
with those running the banks. However, the scale and breadth of
regulatory failure was also shocking. International capital requirements
led to the FSA becoming mired in the process of approving banks'
internal models to the detriment of spotting what was going on
in the real business. Many of the FSA's failings were shared by
regulators of other countries. However, this does not absolve
UK regulators from blame. They neglected prudential supervision
in favour of a focus on detailed conduct matters. Along with many
others, including accountancy firms and credit ratings agencies,
the FSA left the UK poorly protected from systemic risk. Multiple
scandals also reflect their failure to regulate conduct effectively.
(Paragraph 931)
182. The
FCA and PRA are new organisations. They have each set out their
aspirations for a new approach. This is welcome. Whether they
meet those aspirations, or whether they repeat mistakes of the
past, remains to be seen. The Commission recommends that the Treasury
Committee undertake an inquiry in three years' time into the supervisory
and regulatory approach of the new regulators. (Paragraph 932)
Real-time supervision
183. The
Commission welcomes the PRA's stated aspiration to pursue a forward-looking
approach to the assessment of banks' capital and liquidity adequacy,
including by assessing the adequacy of asset valuations. In exercising
judgement in real time, regulators will need to steer a course
which ensures that they do not assume a position as shadow directors
and should bear in mind that it is the directors of banks, and
not the regulators, who are answerable to shareholders. The regulators
have acknowledged that their judgements will sometimes be wrong.
They will need to accept that bankers will make wrong judgements
too. It will be important that supervisory judgements are made
in real time and not based on a view taken with the benefit of
hindsight. Account will need to be taken of the information reasonably
available to banks at the time decisions were taken. Banks are
in the business of taking risk and regulators should not create
an atmosphere in which normal operations become stifled because
of fear of regulatory actions in years ahead. However, the mere
fact that the regulator did not identify a risk will not necessarily
absolve individuals in banks from responsibility. (Paragraph 941)
184. The
Treasury Committee asked the PRA to examine how it will minimise
the risk of appearing to act as shadow directors under their new
approach to regulation, and to publish its findings. It asked
the same of the FCA. Something more substantial than the assurances
given to date is required. The regulators should publish a further
considered response to the risk that they may appear to be acting
as shadow directors. They will need to do so in the light of recommendations
elsewhere in this Report and other reforms already in train. The
Commission recommends that the regulators report to the Treasury
Committee within six months. The Commission further recommends
that the Treasury Committee, in its inquiry on the supervisory
approach of the regulators, take further evidence on this issue.
(Paragraph 942)
185. The
FCA is housed in the same building as the former FSA, has many
of the same staff, and many of the same systems as the FSA. These
continuities will make the transfer to a new judgement-based approach
more difficult for the FCA than for the PRA. Other challenges
arise from the need to move away from gathering vast quantities
of data and low-level analysis. The FCA should ensure that all
data requests have a clearly articulated purpose. The Commission
recommends that the Treasury Committee, when undertaking its inquiry
into the supervisory approach of both regulators, assess whether
the FCA's approach to data collection has been appropriate. Given
that banks have been given notice of this inquiry, any complaints
by them about excessive data collection would need to be supported
by evidence. It is not enough to complain only in private. (Paragraph
946)
186. The
FCA has powerful new tools to intervene in products. These should
not mask the fact that responsibility for the design and appropriate
marketing of products lies with banks. The relationship between
the FCA and banks should be such that concerns about products
are resolved without recourse to the FCA's new tools. Their use
by the FCA will carry significant risks. How the FCA's new product
intervention tools are used will be a key indicator of its success
in taking a judgement-led approach. The balance between intervening
too early, distorting the market, and too late, potentially allowing
customers to suffer, will be a delicate one, and how these tools
are used will be an indicator of the FCA's success in taking a
judgement-based approach. The Commission recommends that the Treasury
Committee specifically consider the FCA's use of its product intervention
tools in its inquiry into the supervisory approach. (Paragraph
953)
187. Those
who design and market products should be held responsible should
those products be mis-sold to consumers. That personal responsibility
must be clear from the way in which responsibilities have been
assigned under the Senior Persons Regime. The nature of financial
products where flaws may not appear for some time after the launch,
and the information imbalances between banks and their customers,
impose a particular duty on banks to test thoroughly what might
go wrong with new products before their launch. It should also
be their duty to ensure that products are not sold to the wrong
people, and that staff incentives do not contribute to mis-selling.
However, if these steps are properly taken, the mere discovery
of risk in products cannot be held to constitute mis-selling,
where such risks could not reasonably have been identified based
on the information available either to the bank or to the regulator
at the time that they were sold. (Paragraph 954)
188. The
Commission notes the new arrangements for super-complaints and,
in particular, that the FCA intends to make the process straight-forward
for designated consumer bodies. The draft guidance appears to
be a step in the right direction by making clear that the FCA
will respond within 90 days, and setting out the action it proposes
to take, with reasons. Given the potential for widespread consumer
detriment arising from the subject of a super-complaint, we consider
that the FCA should provide clear reasons when it does not consider
that initiation of a collective consumer redress scheme is appropriate.
It is important that proper, evidence-based, judgement is applied
when handling super-complaints and that the 90-day time limit
does not result in a process-driven approach. (Paragraph 957)
Supervisor relationship with banks
189. A
successful relationship between banks and regulators will depend
on regular, frank discussions between the senior regulators and
senior bank executives, including at chief executive level, that
focus on important issues. Such a relationship should also be
fostered by periodic attendance of the most senior regulators
at the meetings of bank boards. The Commission recommends that
the FCA and the PRA keep a summary record of all meetings and
substantive conversations held with those at senior executive
level in banks, the most senior representative of the FCA or PRA
present in each case. We would expect those records to be made
available on request retrospectively to Parliament, usually to
the Treasury Committee. (Paragraph 965)
Special measures
190.
The advantages of twin peaks regulation have been set out elsewhere
in this Report. However, it also carries the risk that, by focusing
on their own individual objectives, the regulators fail to spot
or tackle systemic weaknesses of leadership, risk management and
control which underpin problems in different parts of the business.
The Commission has concluded that the regulators should have available
to them a tool, along the lines of the pro-active approach taken
in the US, to identify and tackle serious failings in standards
and culture within the banks they supervise. Use of the tool may
be a precursor to formal enforcement action by the regulator if
the bank fails to address the regulator's concerns satisfactorily.
(Paragraph 970)
191. As
part of the continuing dialogue between the PRA and the FCA at
the most senior levels within the two organisations, and through
their risk assessment frameworks, we expect the two regulators
to consider cases which might require the deployment of the tool
we propose, which can be termed 'special measures'. Special measures
will take the form of a formal commitment by the bank to address
concerns identified by the regulator. Ahead of placing a bank
in special measures, we consider that the regulators should commission
an independent report to examine the extent to which their initial
source of concern may be an indicator of wider conduct or standards
failings. It will be important for such reports to be truly independent.
We consider it inappropriate therefore for a bank's auditors,
or those who might compete to become the firm's auditors in the
near future, to be appointed to carry out this task. There would
be an expectation that reports would be prepared quickly. (Paragraph
971)
192. Where
the report reveals problems requiring rectification or there remains
cause for regulatory concern, the Commission recommends that the
regulators have a power to enter into a formal commitment letter
with the bank concerned to secure rectification measures and to
provide a basis for monitoring progress in addressing the concerns.
The Commission recommends that a bank in special measures be subject
to intensive and frequent monitoring by the regulators. An individual
within the bank should be made responsible for ensuring that the
remedial measures are implemented to the regulators' satisfaction.
As part of this process, the regulators might wish to require
the retention of an independent person to oversee the process
from within the bank. The board's overall duties for rectification
would not be in any way diluted by the identification of an individual
within the bank responsible for implementing remedial measures
or the retention of an independent person. (Paragraph 972)
193. Before
the deployment of special measures, we would expect the regulators
to notify the bank in question, and give the leadership of that
bank a reasonable opportunity to demonstrate that it is addressing
the concerns of the regulators or to convince the regulators that
the concerns are misplaced. (Paragraph 973)
Supervisory resources
194. The
regulators have not customarily ensured that their staff acquire
awareness of previous financial crises, even though it is evident
that there is repetition in the underlying causes. This is a serious
omission. The PRA should ensure that supervisors have a good understanding
of the causes of past financial crises so that lessons can be
learnt from them. (Paragraph 982)
195. The
most recent increase in regulatory costs is intended to be largely
transitional. A strategic aim of the FCA should be to become a
smaller, more focused organisation. The Commission recommends
that the FCA replicate the Bank of England's stated intention
for the PRA to operate at a lower cost than its equivalent part
of the FSA, excluding what is required to fund new responsibilities.
The FCA should set appropriate timescales for implementation of
this recommendation. (Paragraph 985)
A role for senior bankers?
196. The
Commission has found the advice and evidence of some experienced
bankers untainted by recent crises extremely helpful in exposing
the flaws that we have identified in the banking industry and
in proposing remedies. The Commission recommends that the PRA
and FCA give consideration as to how best they can mobilise the
support and advice from the accumulated experience of former senior
management in the banking industry. (Paragraph 991)
Regulatory framework
197. The
international regulatory approach implemented through Basel II
was deeply flawed. Basel III and the associated EU legislation
do not address these flaws adequately. Indeed, they add further
layers of complexity, and continue to allow large banks to use
unreliable internal models to calculate their capital requirements.
Increased complexity in regulation creates an illusion of control
by regulators, but in practice it leads to less effective regulation.
The Bank of England should report to Parliament on the extent
to which, in its view, the shortcomings of Basel II have been
addressed by Basel III, and whether they consider that any improvement
to the process through which the Basel accords are agreed could
lead to better outcomes. (Paragraph 997)
198. Given
the UK banking sector's considerable size, it is important that,
if the pace of international change in banking regulations is
not sufficiently rapid, the UK should do more at a national level
to address the deficiencies. The Commission notes that steps are
already being taken by the PRA in that direction. The PRA should
provide an explanation if it considers that there are legal constraints
at a European level which prevent them from pursuing the desired
regulatory approach. (Paragraph 998)
199. Progress
by regulators internationally in weaning themselves off dependence
on credit rating agency ratings for the purpose of assessing capital
adequacy is essential. The Commission recommends that the regulators
prepare a report for Parliament on progress made and further plans
for action by June 2014. (Paragraph 1002)
200. The
Commission is disappointed at the Government's negative response
to our recommendation in our First Report that the FPC be given
responsibility for setting the leverage ratio. We have two major
concerns. First, we consider that the 3 per cent minimum leverage
ratio is too low. Second, we see no good reason for the Government's
proposal to delay a review of the FPC's proposed power to determine
leverage ratios until 2017. We note that the Chancellor's explanation
regarding the Government's rejection of a higher leverage ratio
relied on allegedly 'compelling' representations to the Treasury
that a higher ratio would cause unintended damage; the Commission
is not persuaded. If problems are created for banks with particular
characteristics, they should be addressed by specific derogations
not by reducing the leverage ratio for all banks. (Paragraph 1011)
201. The
Commission has heard further evidence since its First Report which
supports its view that the leverage ratio should be set substantially
higher than the 3 per cent minimum proposed under Basel III. We
noted in our First Report that the leverage ratio is a complex
and technical decision best made by the regulator and it should
certainly not be made by politicians. We recommended that the
FPC should be given the duty of setting the leverage ratio from
Spring 2013. We are disappointed that the Government has not accepted
this recommendation. (Paragraph 1012)
202. If
the regulators' and supervisors' independence is to be meaningful,
the setting of the leverage ratio must form part of their discretionary
armoury. We urge the Government to reconsider its position on
responsibility for the setting of the leverage ratio. Were the
Government to maintain its current position, the Commission further
recommends that the newly-established FPC publish its own assessment
of the appropriate leverage ratio. This will bring transparency
to any gap between the preference of skilled policy-makers and
the views of politicians. The latter are at risk, particularly
in the current environment where several banks are still wholly
or partly State-owned, of succumbing to bank lobbying. Furthermore,
the FPC should consider explicitly the question of whether the
leverage ratio should be a regulatory front-stop rather than a
back-stop given the recognised deficiencies in the risk-weighted
assets approach to assessing capital adequacy. This work should
be completed and the results made public by the end of the year.
(Paragraph 1013)
Aligning tax rules with regulatory objectives
203. The
extent to which tax rules encourage leverage in banks is disputed
but the fact that they do provide an incentive is not. Tax rules
are misaligned with regulatory objectives in that they reward
banks for financing their activities through issuing debt rather
than equity and so increase leverage, and create a disincentive
for banks to hold capital in the most loss absorbent form. Removing
the tax bias could address this misalignment and contribute generally
to financial stability. (Paragraph 1018)
204. While
there are likely to be winners and losers within the banking sector
from any tax reform, the Commission recommends that the potential
financial stability benefits afforded by a neutral tax system
are sufficiently important that the Government should consult
on whether to introduce a limited form of an Allowance for Corporate
Equity for the regulated banking sector alongside an uplift in
the Bank Levy to offset the cost to the Exchequer in full. (Paragraph
1026)
Accounting for regulatory needs
205. The
Commission recognises that the way in which IFRS affects banks
cannot be solved by UK accounting standard-setters alone. Reform
of accounting standards should better reflect the needs of bank
regulators and investors, including the process by which IFRS
is adopted into EU law, and should be a priority for the Government
in relevant international negotiations. (Paragraph 1030)
206. The
introduction of an expected-loss model for valuation of debt assets
held to maturity might represent a beneficial change to international
accounting standards. However, we are concerned at the slow pace
of consideration of this change and the particular effect this
has on investor confidence in the balance sheets of banks. The
Commission therefore recommends that the FRC prioritise an early
decision on the expected-loss model for the banking sector in
EU negotiations. (Paragraph 1033)
207. While
we recognise the risk of ever more complex and burdensome accounting
requirements, flaws in IFRS mean that the current system is not
fit for regulators' purposes. The Commission recommends that non-EU
mandated regulatory returns be combined, with any other accounting
requirements needed, to create a separate set of accounts for
regulators according to specified, prudent principles set by the
regulator. This second set of accounts should be externally audited
and the Commission recommends that a statutory duty to regulators
be placed upon auditors in respect of these accounts. Where there
is a public interest for these accounts to be published, the regulator
should have a legal power to direct that they (or where appropriate,
abbreviated accounts) are included in the financial statements,
alongside a reconciliation to the IFRS accounts. (Paragraph 1039)
Clearer auditors' reports
208. An
enhanced auditor commentary would benefit investors and other
users of financial statements. We welcome the IAASB's work to
develop a model for best practice. However, we consider that subjective
matters of valuation, risk and remuneration, amongst other key
judgement areas, are so crucial to investors' understanding of
a bank's business model that an upfront, independent opinion would
be beneficial. The Commission therefore recommends inclusion of
specific commentary on these areas in auditors' reports on banks'
accounts. (Paragraph 1042)
It's good to talk
209. There
are significant areas of overlap in the work of HMRC and the regulators.
Rules related to information sharing between authorities are governed
by EU law. It is important that confidentiality rules are respected.
The Commission recommends that HMRC, PRA and FCA jointly publish
a paper setting out how they intend to bring about appropriate
useful sharing of information and expertise within the existing
rules. The PRA should consider using its powers to commission
reports on a specific function of a bank's business on behalf
of HMRC. This might include commissioning reviews on tax risk
management and financial transfer pricing. The Commission recommends
that the National Audit Office undertake a periodic review of
how effectively the PRA uses its powers to promote information
sharing. (Paragraph 1047)
210. There
appears to be general agreement that effective communication between
auditors and supervisors is crucial. However, in the past the
relationship between supervisors and auditors has been dysfunctional.
The Commission recommends that the Court of the Bank of England
commission a periodic report on the quality of dialogue between
auditors and supervisors. We would expect that for the dialogue
to be effective, both the PRA and the FCA would need to meet a
bank's external auditor regularly, and more than the minimum of
once a year which is specified by the Code of Practice governing
the relationship between the external auditor and the supervisor.
This should be required by statute, as recommended by the House
of Lords Select Committee on Economic Affairs. Representatives
of the audit profession should also have the opportunity to discuss
emergent issues that have arisen from their work with banks with
the PRA, the FRC and HMRC. We expect that this would require thematic
meetings. (Paragraph 1053)
The new regulatory structure and our approach
211. A
fundamental change in the structures for the regulation of the
financial services sector, including banking, has just come into
effect. This has involved a major upheaval for the regulators
and the regulated, albeit with a potential for benefits in the
future. In view of the radical and recent nature of this upheaval,
we have concluded that no purpose would be served by recommending
further fundamental changes in regulatory structures hard upon
the heels of those recently introduced. (Paragraph 1064)
Regulatory objectives
212. The
Commission has concluded that the PRA should be given a secondary
competition objective. A 'have regard' to competition simply does
not go nearly far enough. As the experience of the FSA shows,
a 'have regard' duty in practice means no regard at all. With
only a 'have regard' duty given to the PRA, the risk is high that
it will neglect competition considerations. This would be of great
concern, given the potential for prudential requirements to act
as a barrier to entry and to distort competition between large
incumbent firms and new entrants. The current legislation strikes
an inadequate balance in this area. (Paragraph 1069)
213. The
case for the FCA to have a strategic objective that can trump
the operational objectives. The strategic objective, as the Chief
Executive of the FCA initially told us, is embodied in the current
operational objectives. The Government has previously argued that
the strategic objective will focus the new regulatory culture
of the FCA. The opposite is the case. The plethora of strategic
and operational objectives sitting alongside a number of duties
and 'have regard' requirements risks diverting the FCA's focus
on its core operational objectives. The Commission recommends
that the FCA's strategic objective of "ensuring that the
relevant markets function well" be dropped. (Paragraph 1074)
214. It
is too early to assess how the FCA is using its competition powers
and whether it is using them effectively. However, we are concerned
that, for a variety of reasons, the FCA could fail to deploy its
new competition powers to full effect. The Commission notes that
the leadership of the FCA has stressed that it takes competition
seriously and intends to use its powers in this area extensively.
This is very welcome. The FCA mustas a matter of priorityembed
a robust pro-competition culture which looks to competition as
a primary mechanism to improve standards and consumer outcomes.
(Paragraph 1078)
Regulatory accountability
215. A
change of approach needs to be deeply embedded in the regulatory
culture if it is to prove enduring. Regulators, too, have interests.
They can all too easily fall back, or be forced back, on to a
narrow interpretation of their statutory responsibilities, indulge
in turf battles, or concentrate on avoiding blame. If regulators
are to be subject to the correct incentives, and are to proceed
in the knowledge that their future decisions will not be without
consequence, it is vital to create the appropriate structures
of accountability for the regulators. (Paragraph 1079)
216. The
Commission recommends that, in line with the recommendations of
the Treasury Committee and the Joint Committee on the Financial
Services Bill, the Bank of England be given a duty to respond
to reasonable reports for information from Parliament. (Paragraph
1093)
217. Although
many institutions can examine what goes wrong in banks, only Parliament
can hold regulators to account. In the past, regulators themselves
have undertaken investigations into bank failures which, where
regulatory failure may also be at issue, is unsatisfactory. The
Treasury Committee used specialist advisers to provide an assurance
that the FSA's report on the collapse of RBSwhich included
an examination of the FSA's own rolewas fair and balanced.
This mechanism also avoided the risk that no report might be produced
at all because of concerns that the regulator might be conflicted.
The report on RBS that was eventually produced has proved to be
of value. In any equivalent case in the future, the Commission
recommends that regulators consider the case for an investigation
led by an independent person appointed with the approval of Parliament.
(Paragraph 1103)
218. The
new, highly complex, regulatory structure represents a further
delegation by Parliament of decision-making powers that formerly
lay with Ministers. Many of these powers could be of great significance
and their use will trigger public debate and generate controversy.
Ministers taking such decisions are accountable to Parliament
and to the electorate, but the new regulatory structure needs
accompanying accountability mechanisms to ensure that Parliament,
and through Parliament the public, have the explanations to which
they are entitled. (Paragraph 1104)
219. Strong
accountability mechanisms are also in the interests of the new
regulators themselves. Without the authority and legitimacy that
comes from being held properly and publicly to account, they are
likely to be less confident in taking difficult and possibly unpopular
decisions. (Paragraph 1105)
220. The
accountability arrangements of the new structures are more complex
than those of the previous regulatory regime. The PRA is a subsidiary
of the Bank, and the FPC is a sub-committee of the Court of the
Bank. Since the Government's proposals for regulatory reform first
emerged in 2010, the future accountability to Parliament of the
new bodies created by that reform appears to have been treated
by those responsible as an afterthought. Progress has been very
slow, and piecemeal changes as the Bill that became the Financial
Services Act 2012 went through Parliament have provided only partial
solutions. It took constant pressure from Parliament to prompt
the Government and the Bank of England to concede even the unsatisfactory
half-way house that is the Oversight sub-committee. Retrospective
reviews of the performance of the Bank of England should be of
value. However, as the power of review is in the hands of a sub-committee
of the Court, rather than the Court itself, the creation of this
body will further complicate the already complex lines of accountability
of the Bank, not least to Parliament. At worst, the new Oversight
sub-committee could end up owing more to form than to substance.
The subordination of the Oversight sub-committee to the Court
as a whole means that Parliament will need to rely, ultimately,
on the Court of the Bankwhich includes the Bank's most
senior executivesto fulfil the Bank's duty of accountability
to the House. This is a serious weakness of the new legislation.
(Paragraph 1106)
221. Accountability
for the new regulatory structure, and in particular the central
and very powerful Bank of England, requires further improvements
in corporate governance. In the case of the Bank, the Commission
considers it essential for the Court to be reformed as far as
possible into a meaningful boardalong the lines recommended
in 2011 by both the Joint Committee on the Financial Services
Bill and the Treasury Committee. The Commission recommends accordingly.
(Paragraph 1107)
222. One
further change is also required, arising from the fact that the
PRA is embedded within the Bank of England. The chief executive
of the PRA, who is the Deputy Governor for Prudential Regulation,
is accountable for the performance of the PRA, but the board of
the PRA is chaired by the Governor of the Bank, the chief executive's
immediate superior within the Bank. This risks the Governor involving
himself in the detailed decisions of the PRA and so undermining
the accountability, and possibly the authority, of the PRA's chief
executive. The Commission recommends that the senior independent
Board member chair the PRA. The Governor should remain a member
of the board of the PRA. (Paragraph 1108)
The new responsibilities
223. In
making our recommendations we have referred in general terms to
the regulators rather than specifying in each case whether the
functions and responsibilities should fall to the PRA or the FCA
or both in cooperation. Nonetheless, it is essential that lead
responsibility be clarified in each case. The Commission recommends
that the FCA, the PRA and the Government prepare, for publication
alongside the Government response to this Report, a proposed allocation
of lead responsibility for each of the recommendations for regulatory
action, directly or in consequence of new legislation, contained
in this Report. (Paragraph 1110)
Physician, heal thyself
224. Our
recommendations on regulatory structures and accountability are
designed to create a framework to ensure that regulators are robustly
independent and focus on using their judgement to achieve the
objectives set for them by Parliament. Regulators' judgements
must ultimately be subject to sufficient democratic accountability
to ensure that a full explanation is given for their decisions.
(Paragraph 1111)
225. A
lesson in our First Report, and this one, is that politicians
can be tempted to heed the blandishments of bankers and succumb
to lobbying. This makes the regulators' job all but impossible.
No-one can tell whether or when these risks may emerge. But the
danger remains. (Paragraph 1112)
226. The
Governor of the Bank of England is, by virtue of his responsibilities
and independence, uniquely well-placed to sound the alarm if bank
lobbying of Government is becoming a concern. The Commission recommends
that it be a specific personal responsibility of the Governor
to warn Parliament, or the public, in such circumstances. (Paragraph
1113)
Warnings from history
227. The
Commission recommends that an additional external member be appointed
to the FPC, with particular responsibility for taking a historical
view of financial stability and systemic risk, and drawing the
attention of FPC colleagues, and the wider public through speeches
and articles, to historical and international parallels to contemporary
concerns. (Paragraph 1115)
Chapter 10: Sanctions and enforcement
Enforcement against banks
228. Effective
enforcement action against firms represents an important pillar
of the overall approach to enforcement. In many cases, it serves
as the gateway to enforcement action against responsible individuals,
which is also necessary. It can draw wider attention to a failure,
providing incentives for firms to strive to maintain high standards,
and establishes penalties when banks depart from those standards.
The record of the regulators in enforcement against firms is patchy
at best. It is notable that both significant prudential failures,
for example at RBS, and some widespread conduct failures in the
selling of PPI did not lead to successful enforcement against
banks. In the investigations those at the top often absolved themselves
by attesting their ignorance about the organisation of which they
were in charge. It would run contrary to the public interest if
the idea were to gain currency that banks can be too big or complex
to sanction. (Paragraph 1129)
229. It
is to be hoped that the LIBOR investigations have set a pattern
for the future. In relation to prudential failings, formal action
will assist in determining what went wrong and help to provide
the basis for pursuing responsible individuals. In relation to
conduct failings, a visible and costly redress process may not
be enough: enforcement has the benefit of more clearly setting
out where failures occurred and that rules were broken, so that
culpability is not obfuscated and so that lessons can be learned.
(Paragraph 1130)
230. It
is right that an element of the fine should fall on shareholders,
to provide a continuing incentive for them to monitor standards
of conduct and supervision within the banks they own. However,
our recommendations on recovery of deferred payments in Chapter
8 are designed to ensure that, in future, a significant proportion
of fines on firms may be met from deductions from the remuneration
of staff of the bank at the time of the misconduct, thereby making
the prospect of fines on firms a more direct incentive on individuals
to prevent it. There should be a presumption that fines on banks
should be recovered from the pool of deferred compensation as
well as current year bonuses. The recovery should materially affect
to different degrees individuals directly involved and those responsible
for managing or supervising them, staff in the same business unit
or division, and staff across the organisation as a whole. The
impact and distribution of fines on deferred compensation should
be approved by the supervisors as part of a settlement agreement.
(Paragraph 1131)
231. Firms
cannot be permitted to regard enforcement fines as a "business
cost". The FSA recognised that in the past the level of its
fines was too low to prevent this. The reforms to its penalty
policy are supposed to address this, but they have yet to be properly
tested, and the credibility of enforcement has been damaged by
a legacy of fines that were pitiful compared to the benefits banks
gained from the misconduct. To provide greater incentives to maintain
high levels of professional standards, both the FCA and the PRA
should be prepared to review again their penalty setting framework
in the future to allow for a further substantial increase in fines.
They should ensure that in responding to any future failures they
make full use of the new rules for calculating fines and build
on the encouraging examples set by the LIBOR fines. If regulators
believe that the current legal framework still inhibits them from
imposing the necessary level of penalties, they should tell Parliament
immediately. (Paragraph 1132)
232. In
its Report on LIBOR, the Treasury Committee concluded that "the
FSA and its successors should consider greater flexibility in
fine levels, levying much heavier penalties on firms which fail
fully to cooperate with them". We agree. Cooperation by firms
in bringing issues to regulators' attention and assisting with
their investigation should be a given. Regulators should make
full use of the flexibility in their penalty policy to punish
cases where this does not occur. However, regulators should also
make it clear to firms that the same flexibility will be used
to show leniency where inadvertent and minor breaches are swiftly
brought to their attention and rectified, so that the fear of
over-reaction does not to stifle the free flow of information.
(Paragraph 1133)
233. A
protracted process of enforcement with a firm can delay enforcement
against individuals, weakening the prospect of its success and
of meaningful penalties, particularly if the delay means that
the individual can continue lucrative work for several more years
and approach retirement. The Commission recommends that the regulators
bear in mind the advantage of swift resolution of enforcement
action against firms, in particular in cases where settlement
with the firm is a precursor to action against responsible individuals.
(Paragraph 1134)
Civil sanctions and powers of enforcement over
individuals
234. Faced
with the most widespread and damaging failure of the banking industry
in the UK's modern history, the regulatory authorities seemed
almost powerless to bring sanctions against those who presided
over massive failures within banks. Public concern about this
apparent powerlessness is both understandable and justified, but
the need for a more effective enforcement regime does and should
not arise from a public demand for retribution. It is needed to
correct the unbalanced incentives that pervade banking. These
unbalanced incentives have contributed greatly to poor standards.
Redress of these is needed not merely as a step to restoring public
confidence, but also to create a new incentive for bankers to
do the right thing, and particularly for those in the most senior
positions fully to fulfil their duties and to supervise the actions
of those below them. (Paragraph 1165)
235. Later
in this chapter, we consider the case for a new criminal offence
specific to the banking sector. However, in the context of civil
sanctions, the Commission has not heard the case advanced for
a range of penalties which go beyond those already available.
The problems, and the proposals for change which follow, reflect
the fact that the sanctions already available to the regulators,
such as very large fines and permanent disbarment from the UK
financial services sector, have so rarely been applied. (Paragraph
1166)
236. The
foundations for a new approach are laid in the Commission's recommendations
in Chapter 6. In that chapter we recommended that a successor
to the Statement of Principles in the form of Banking Standards
Rules designed to ensure that the full range of enforcement tools
could be applied to a wider range of individuals working in banking.
This would be supported by a system of licensing administered
by individual banks, under the supervision of the regulators,
to ensure that all those subject to the Banking Standards Rules
were aware of their obligations. This approach would prevent one
barrier to effective enforcement that we identified, namely that
regulators lacked effective powers to sanction misconduct by bankers
who were not Approved Persons. (Paragraph 1167)
237. In
Chapter 6 we made another proposal designed to address one of
the most dismaying weaknesses that we have identified, whereby
a combination of collective decision-making, complex decision-making
structures and extensive delegation create a situation in which
the most senior individuals at the highest level within banks,
like Macavity, cannot be held responsible for even the most widespread
and flagrant of failures. We proposed the establishment of a Senior
Persons Regime to replace the Approved Persons Regime in respect
of banks, whereby all key responsibilities within a bank would
be assigned to a specific, senior individual. Even where certain
activities in pursuance of the responsibility were either delegated
or subject to collective decision-making that responsibility would
remain with the designated individual. The Senior Persons Regime
would be designed to ensure that, in future, it should be possible
to identify those responsible for failures more clearly and more
fairly. This should provide a stronger basis for the use of enforcement
powers in respect of individuals. (Paragraph 1168)
238. These
changes would also need to be accompanied by a change of approach
from the regulators. In respect of insider trading, the increased
effectiveness of criminal enforcement owes less to changes in
the law than changes in the approach of the regulators, in particular
to a realisation that a large-scale commitment of time, effort
and resources to seeing cases through is both necessary and worthwhile.
The same determination has not been so apparent in enforcement
action relating to bank failures, LIBOR or mis-selling. At the
root of this failure has been what the regulators themselves have
characterised as a bottom-up approach. A key to success in the
future is likely to be a top-down approach, drawing on the clarity
that the Senior Persons Regime is intended to provide about who
is exercising responsibility at the highest levels, what they
knew and did, and what they reasonably could and should have known
and done. (Paragraph 1169)
239. The
proposal to create a rebuttable presumption that directors of
failed banks should not work in such a role again is a well-intentioned
measure for addressing the difficulty of proving individual culpability,
but it is a blunt instrument with several weaknesses. The blanket
imposition of a rebuttable presumption risks having perverse and
unfair effects; it will act as a disincentive for new directors
to come to the aid of a struggling bank; it could encourage power
structures in which key decision-makers eschewed the title and
responsibility of director. Furthermore, the Government proposal
as it stands is too narrow to be of significant use. Notably,
it would probably not have been triggered in most of the recent
scandals ranging from the bail-outs of RBS and HBOS to PPI mis-selling
and LIBOR manipulation. We have concluded that a more effective
approach than the blanket imposition of a rebuttable presumption
would be one which reverses the burden of proof in a wider, but
clearly defined, set of circumstances covering both prudential
and conduct failures. (Paragraph 1170)
240. Greater
individual accountability needs to be built into the FCA's and
PRA's processes. The Commission recommends that legislation be
introduced to provide that, when certain conditions are met, the
regulators should be able to impose the full range of civil sanctions,
including a ban, on an individual unless that person can demonstrate
that he or she took all reasonable steps to prevent or mitigate
the effects of a specified failing. The first condition would
be that the bank for whom the individual worked or is working
has been the subject of successful enforcement action which has
been settled or upheld by tribunal. The second condition is that
the regulator can demonstrate that the individual held responsibilities
assigned in the Senior Persons Regime which are directly relevant
to the subject of the enforcement action. (Paragraph 1171)
241. The
FSA made the case for a power to impose an interim prohibition
on individuals against whom enforcement action has been commenced.
The case made by the FSA was not clearly targeted on banks. An
interim prohibition could cause serious harm if used unfairly
or arbitrarily. In the case of very small financial firms in particular,
having a key individual prohibited for even a short period might
cause irreparable damage to their reputation and see clients leave
never to return, even though the case might be dropped or not
upheld. Given that the FSA has only rarely taken public enforcement
action against senior individuals in large banks, it may be that
the cases through which they have identified the need for a suspension
power involve smaller firms or non-bank financial institutions.
Based on our consideration of issues relating to banking standards,
the Commission has concluded that the case has not been made for
providing the regulators with a general power to impose interim
prohibitions on individuals carrying out controlled functions
in the financial services sector. (Paragraph 1172)
242. The
current time limit of three years between the regulator learning
of an offence and taking enforcement action against individuals
could act as a constraint on the regulators' ability to build
credible cases. This could be a particular barrier to the regulators'
ability to place greater priority on pursuing senior individuals
in large and complex banks, as we are recommending. In view of
our proposal that enforcement action against a firm must be completed
before the regulator can deploy the new tool of a reversed burden
of proof, more than three years may well be required to complete
this process and make the new tool usable. The Commission recommends
that the Government should address this problem by allowing for
an extension of the limitation period in certain circumstances.
However, swift enforcement action should be the priority. Regulators
should be required retrospectively to provide a full explanation
for the need to go beyond three years. They can expect to be challenged
by Parliament if it were to transpire that they were using this
measure as an excuse for delaying enforcement action. (Paragraph
1173)
A new criminal offence?
243. The
Commission has concluded that there is a strong case in principle
for a new criminal offence of reckless misconduct in the management
of a bank. While all concerned should be under no illusions about
the difficulties of securing a conviction for such a new offence,
the fact that recklessness in carrying out professional responsibilities
carries a risk of a criminal conviction and a prison sentence
would give pause for thought to the senior officers of UK banks.
The Commission recommends that the offence be limited to individuals
covered by the new Senior Persons Regime, so that those concerned
could have no doubts about their potential criminal liability.
(Paragraph 1182)
244. The
Commission would expect this offence to be pursued in cases involving
only the most serious of failings, such as where a bank failed
with substantial costs to the taxpayer, lasting consequences for
the financial system, or serious harm to customers. The credibility
of such an offence would also depend on it being used only in
the most serious cases, and not predominantly against smaller
operators where proving responsibility is easier, but the harm
is much lower. Little purpose would be served by the creation
of a criminal offence if the only punishment available to the
courts were the imposition of a fine, because substantial fines
can already be levied as a civil sanction with a lower burden
of proof. We would expect the determination of the available sentences
to have regard to relevant comparable offences. (Paragraph 1183)
245. It
is inappropriate that those found guilty of criminal recklessness
should continue to benefit from remuneration obtained as a consequence
of the reckless behaviour. Fines may not claw back the full amount.
The Commission recommends that the Government bring forward, after
consultation with the regulators and no later than the end of
2013, proposals for additional provisions for civil recovery from
individuals who have been found guilty of reckless mismanagement
of a bank. (Paragraph 1184)
246. The
Commission's support in principle for a new criminal offence is
subject to an important reservation. Experience suggests that,
where there is the possibility of a criminal prosecution, public
disclosure of failings might be greatly limited until the criminal
case is finished. It is important to expedite any civil sanctions
against individuals and to publish information into banking failures
in a timely manner. The Commission recommends that, following
a successful civil enforcement action against a bank, the decision
on whether to bring criminal proceedings against relevant Senior
Persons must be taken within twelve months. (Paragraph 1185)
Enforcement decision-making
247. There
is an inherent tension between the role of real-time regulators
and the enforcement function, which can involve reaching judgements
about matters in which supervisors were involved at the time.
Regulators are also focused on the big picture, such as maintaining
financial stability. Greater priority needs to be placed on the
role of enforcement, with adequate resources devoted to this function
and leadership with a willingness to pursue even the difficult
cases, often involving the larger and more powerful players, in
order to build up a credible deterrent effect. (Paragraph 1199)
248. A
higher priority for the enforcement function could be achieved
by replacing the Enforcement and Financial Crime Division of the
FCA with a separate statutory body, which might also assume the
enforcement functions of the PRA. However, we have concluded that
to propose this change now would involve a new organisational
upheaval for the financial services regulators, almost immediately
after a major set of organisational changes have come into effect.
(Paragraph 1200)
249. We
have, however, concluded that the body responsible for making
enforcement decisions arising from the work of the Enforcement
and Financial Crime Division of the FCA, namely the Regulatory
Decisions Committee, is not best-suited to the specific enforcement
needs of the banking sector. At the moment, the Committee's composition
seems to offer the worst of all worlds; it appears to contain
neither a depth of banking expertise nor a clear lay element separate
from banking and allied financial services sectors. (Paragraph
1201)
250. The
Commission recommends the creation of an autonomous body to assume
the decision-making role of the Regulatory Decisions Committee
for enforcement in relation to the banking sector. The body should
have a lay (non-banking or financial services professional) majority,
but should also contain several members with extensive and senior
banking experience. The body should be chaired by someone with
senior judicial experience. The body should have statutory autonomy
within the FCA. It should be appointed by agreement between the
boards of the FCA and PRA. The body should also assume responsibility
for decision-making in respect of enforcement action brought by
or under the auspices of the PRA. The new body should publish
a separate annual report on its activity and the lessons for banks
which emerge from its decisions, and the chairman should appear
before Parliament, probably the Treasury Committee, to discuss
this report. The Commission further recommends that the FCA and
the PRA be required to publish a joint review of the working of
the enforcement arrangements for the banking sector in 2018. This
should, as part of its work, consider whether a separate statutory
body for enforcement as a whole has merit. (Paragraph 1202)
Chapter 11: The way forward
251. The
Commission has made a large number of proposals for legislative
and regulatory action. We have not usually specified whether they
require primary legislation. The Commission recommends that in
its response to this Report the Government, in cooperation with
the regulators, set out the timetable for implementation of each
of our recommendations, and specify those that will require primary
legislation. As a general rule, we consider that those recommendations
requiring primary legislation should be implemented through amendment
to the Financial Services (Banking Reform) Bill. In any case where
the Government does not propose to implement a recommendation
requiring legislative action through an amendment to that Bill,
the Commission recommends that, in its response to this Report,
it set out its plans for taking forward such legislation. (Paragraph
1205)
252. In
the first instance, we expect that the detailed task of monitoring
progress in the banking sector and its regulation, along with
steps taken to implement the Commission's recommendations, will
fall to Parliament. It will also be for Parliament to consider
whether the rate of progress, or its absence, within the UK banking
sector merits the establishment of a successor to this Commission
at some time in the future. (Paragraph 1206)
253. The
proposals of this Commission can do much to enable the Government,
regulators and above all the industry itself to remedy the shortcomings
in standards set out in this Report. The challenge for Government
is to follow through on the commitment to far-reaching reform.
The challenge for regulators, in implementing planned reforms
and the Commission's proposals, is to give substance to their
commitment to a greater exercise of judgement. (Paragraph 1208)
254. The
greatest challenge lies with the banks. It also represents a great
opportunity. By making constructive use of the recommendations
of this Report and by supporting their spirit as well as the letter,
the banks can, over a period, earn the respect of the public,
and thereafter regain their trust. Everyone can be the beneficiary.
Implementation of the agenda we have set out for higher standards
will lead to an industry which better serves both its customers
and the needs of the real economy. It will also further strengthen
the position of the UK as the world's leading financial centre.
If implemented, our proposals can change banking for good. (Paragraph
1209)
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