Changing Banking for Good - Parliamentary Commission on Banking Standards Contents

9  Regulatory and supervisory approach


909. The failure of regulators to prevent a decline in banking standards is as remarkable as their failure to spot the accumulation of systemic risk and to identify appalling conduct failures, such as the widespread mis-selling of PPI and interest rate swaps, and LIBOR manipulation. The public might be left wondering what purpose was served by almost 4,000 regulatory staff at a cost of around £500m, the bill for which is ultimately footed by the consumer.[1493] Just as astonishing is that, in their evidence to the Commission, the FSA did not identify regulatory failure as a cause of the decline in trust in banks.[1494]

910. In Chapter 3, we identified one of the underlying causes of the decline in standards and culture in banks to be the instinct of regulators towards process and monitoring compliance on the basis of complex rules. In this chapter we explore the new approach to the regulation and supervision of banks that the recently-established new regulators—the Prudential Regulation Authority and the Financial Conduct Authority—intend to take and consider both the scope and the limits of such regulation to improve banking standards and culture. We consider, in particular, the challenges of the new judgement-based approach, the supervisory relationship with banks and the constraints of the international regulatory environment. We discuss the roles that tax and accounting play in influencing bank incentives, particularly with regards to leverage and valuation of assets, and the need for tax and accounting to align better with the regulatory environment. We also consider how auditors can better support regulatory objectives.

New regulatory architecture

911. Major changes in the UK regulatory architecture came into force on 1 April 2013. These involved the establishment of a new prudential regulator, the Prudential Regulation Authority (PRA), a subsidiary of the Bank of England, and a new conduct regulator, the Financial Conduct Authority (FCA). The PRA will be responsible for prudential supervision while the FCA has responsibility for consumer protection, market integrity, and building competitive financial markets. The reforms have also involved the establishment of the Financial Policy Committee (FPC) within the Bank of England. This new macro-prudential regulator has the task of identifying and addressing systemic risks in the banking sector.

912. The new structure should bring benefits from transferring responsibility for prudential supervision to the central bank. Sir Mervyn King has pointed out: "one of the reasons for putting the PRA inside a central bank is to integrate the work of the two institutions more closely", which should result not only in more effective supervision but, in longer term, cost savings.[1495] We discuss the new regulatory architecture later in this chapter.

Regulatory failure


913. The principal responsibility for the failure of the banks lies with the banks themselves, but in the run up to the crisis, regulators around the world failed to clamp down on excessive risk and ensure the banks were resilient enough to survive the storm which came. That such regulatory failures occurred in many different countries suggests it is not a specific regulatory design which is key but instead a regulatory attitude and approach. By the same logic, while regulatory change is necessary in the wake of the crisis, it would be a mistake to assume that rearranging the regulatory pieces in any individual country will on its own make a huge difference unless regulatory attitudes also change.

914. The regulatory failures of the past decade were catastrophic. The failure by prudential supervisors to ensure that banks had adequate capital, liquidity, and asset quality contributed to the financial crisis and the bank bailouts that cost the taxpayer huge sums of money. Failings in conduct supervision allowed serious misconduct, including the widespread mis-selling of PPI and LIBOR manipulation to continue undetected or unchallenged for a long period of time.

915. The FSA pointed out in their Report, The Failure of the Royal Bank of Scotland, that failings were the result, in part, of a "light-touch" approach to regulation which arose from "a sustained political emphasis on the need for the FSA to be 'light touch' in its approach and mindful of London's competitive position."[1496] That same report identified deeper failings, both to look at the right issues and to draw lessons from the issues they did examine, which can be summarised as a neglect of prudential risk and putting form before substance in conduct regulation.


916. Evidence suggests that in the period preceding the financial crisis, the FSA failed to focus sufficiently on substantive prudential issues.[1497] Lord Turner told us:

    I would accept that on the prudential side we clearly diverted from a true interpretation of a risk-based approach. On the prudential side, three things matter: capital, liquidity and asset quality. This is the absolute core of what prudential supervision is about. If you look at what we were doing on RBS and HBOS at that time, there was not enough focus.[1498]

Andrew Bailey told the Treasury Committee:

    the FSA [...] found it very difficult to achieve a stable balance between prudential and conduct priorities.[1499]

Prudential risk issues appeared to be scarcely on the FSA Board's radar screen. According to the FSA's Report, The Failure of the Royal Bank of Scotland, an analysis of the FSA's Board minutes during the 19 months prior to the financial crisis showed that of the major topics discussed, only one out of 61 related in some way to bank prudential risks, just one out of 110 items reported to the FSA Board within the CEO's report were prudential issues, and of 229 items reported by the Managing Director of Retail Markets to the Board, only five were prudential issues.[1500]

917. In their report into the failure of RBS, the FSA accepted that prudential supervisors did not sufficiently assess and challenge key strategic decisions and business model risks.[1501] As a result, banks were able to adopt aggressive growth strategies aimed at maximising short term profits. Sir Mervyn King argued in a speech in 2011:

    It did not take complex reporting to see that the balance sheet of the banking system nearly trebled in five years, or that leverage ratios had reached levels of 50 or more. The obsession with detail was in fact a hindrance to seeing the big picture.[1502]

We were also told that the FSA's immediate response to the financial crisis did not address the failure to focus on major risk issues. A major UK bank told us:

    in the immediate aftermath of the crisis and the bank failures in the UK, the FSA reacted by introducing a multitude of new rules and reporting requirements.[1503]

Andrew Bailey told the Treasury Committee:

    The FSA began a programme of "intensive and intrusive" prudential supervision. This had some successes in rectifying the pre-crisis failings of not concentrating sufficiently on prudential supervision, but such a process can lead to extremely detailed work.[1504]

This view was echoed by a bank, which told us that:

    In the rush to correct the flaws in the existing regulatory framework there has been insufficient prioritisation of regulatory changes, inadequate focus on the interaction between different sets of changes, and too much emphasis on new rules rather than better supervision.[1505]


918. The international prudential regulations in the run up to the financial crisis, implemented under the Basel II accord, were deeply flawed, resulting in lower levels of regulatory capital held by banks. Carol Sergeant, former CRO, Lloyds Banking Group, told us:

    if you used your internal model to derive the capital requirement, you typically ended up with a lower level of capital, so there was an enormous incentive, then that just took off mightily. You can see from the aggregate statistics that the amount of capital held in the banking system, relative to the volumes of business written and the risk-taking, just got smaller and smaller.[1506]

Andy Haldane told us that by allowing banks to use their own internal models to calculate risk weightings of assets:

    we were asking people to mark their own examination papers. The consequences of that have been in some ways entirely predictable. We have seen banks holding progressively less capital against their exposures.[1507]

919. Martin Taylor described to us how the introduction of international regulations under Basel accords encouraged regulators to hide behind rules and cease to apply regulatory judgement:

    One of the things that went wrong of course was that the regulators stopped having a view on capital requirements. They outsourced it all to the Basel rules[...] everything went to the automaticity of Basel I and then Basel II, where people were free, if they wanted to, to game the system. It was very easy to hold less regulatory capital than you perhaps really needed to hold—you were following the rules, but you were not being especially sensible.[1508]

Not only was the design of Basel II flawed but the process of approving banks' internal models proved an enormous distraction from routine supervisory work. Carol Sergeant told us that:

    They made it very difficult for themselves to see the wood for the trees. They [..] used up a huge amount of their energy and capacity dealing with all these models, and I suspect that they did not have enough time left over to go and do the common sense tyre-kicking.[1509]

Michael Foot, former Managing Director of the FSA, described Basel II as "immensely complex and immensely resource-demanding" and "a complete waste of time".[1510] The distraction proved catastrophic, as regulators failed to focus on the real risks emerging within banks in the critical areas of asset quality and liquidity. Carol Sergeant told us:

    I was very concerned because people were not coming in just looking at the basics, for example, of how our credit risk was run or how our liquidity was managed [...], I got in touch with colleagues at the FSA and said, "You are sending in junior technicians who are having a jolly interesting intellectual debate about what is going on in the bottom left-hand corner of a model, but nobody is coming in and taking a thoroughly good view of how we are managing credit". [1511]

920. The regulators paid insufficient attention to emerging funding and liquidity risks as banks increasingly funded themselves through short term interbank funding, while failing to hold a sufficient level of liquid assets. Michael Foot recalled:

    when I started at the Bank of England, the liquidity requirement was simple: 30 per cent of assets were to be held in liquid form. By about 2007, I believe, on the same basis of calculation, that number would have been down to about 4 per cent[1512]

As noted in our Fourth Report into the failure of HBOS, Clive Briault, former Managing Director, FSA, considered that one of the reasons for deficiencies in the framework for monitoring liquidity risk was that the FSA was under pressure from banks to wait for global liquidity regulations to be developed.[1513] There was also an absence of forward-looking stress testing of liquidity scenarios, which, according to evidence taken during our review of HBOS appears only to have become a focus of attention for the FSA in late 2007, when they wrote to the bank to request stress tests to be performed.[1514] This was a case of far too little too late.


921. The FSA's approach to conduct supervision focused primarily on implementation of its Treating Customers Fairly initiative, which was one of two priorities for the regulator in the period preceding the financial crisis (the other being Basel II implementation).[1515] It is to be noted that when statutory regulation came in under the FSA, the Banking Code Standards Board, a self-regulatory body of the banking industry, remained in place with responsibility for monitoring and enforcing standards covering deposits, current accounts, savings, personal loans, credit cards and ATMs. These were only taken over by the FSA in September 2009.[1516]

922. In January 2005, the sale of PPI (along with other general insurance) was added to the FSA's statutory remit, which required the FSA to regulate the conduct of around 20,000 new firms.[1517] Despite its prioritisation of Treating Customers Fairly, the FSA failed to protect consumers from the mis-selling of PPI, which Carol Sergeant described as "a massive regulatory failure".[1518] The FSA admitted that in this case it did not consider a wider perspective, which led to a failure to assess the problem properly:

    The FSA lacked the capability to do market wide analysis which could have informed our thematic work.[1519]

The response of the FSA to mis-selling was the creation of more rules. Eric Daniels, former Chief Executive, Lloyds Banking Group noted that:

    in 2005, we had 173 new rules that were asked for in ICOB [...]. With each thematic review came more changes.[1520]

Gordon Pell, former Chairman, Retail Banking and Wealth Management, and Chief Executive, Retail Markets, RBS, told us:

    It actually got down to, "This box ought to be this size, rather than this size." I think a lot of this could have been changed if someone had come in '05 and said, "We don't need to go through any of that. We think, as a matter of principle 6, this is treating customers unfairly. Please explain yourselves."[1521]

However, this attitude shows that major banks had effectively outsourced how to treat their customers and their responsibilities to the regulator. It is irresponsible for senior executives to seek to deny responsibility by blaming the regulator for not stopping the poor practice and unfair treatment over which they presided.

923. The Financial Ombudsman Service (FOS) wrote to the FSA to point out that their response, which centred around individual customer complaints, was not appropriate given the scale of the problem. Natalie Ceeney, Chief Executive of the FOS, told us:

    what we were proactively calling for was to move away from the idea that every individual had to complain, because the scale was so great in 2008 [...] One of our big disappointments was that that advice was unheeded. We are now in a situation in which 50 million PPI policies have been sold and we are just waiting for everyone to complain, and that still does not feel like the right answer.[1522]

924. Deficiencies in conduct supervision were also evident in the failure by the FSA to identify widespread LIBOR manipulation or to hold individuals to account for these failings, as we discuss in Chapter 10.


925. As noted earlier, conduct and prudential supervisors failed to focus on major risks and instead spent their time implementing processes and monitoring compliance against rules and detailed risk mitigation plans. Alistair Clark, a former member of the Bank of England's interim FPC, has described this as a supervisory approach that "relied too heavily on detailed rules and did not require, or give enough room for, the exercise of judgement".[1523] In written evidence, a major UK bank told us:

    The mix of regulated firms from the globally systemic, to small branches of overseas banks to the tens of thousands of IFAs, meant that a great deal of the work was process driven rather than big picture judgement.[1524]

Sir Mervyn King has explained that such an approach does not support financial stability:

    Process—more reporting, more regulators, more committees—does not lead to a safer banking system.[1525]

926. At the heart of the FSA's processes for both prudential and conduct supervision was the risk assessment framework known as ARROW.[1526] ARROW assessments were extremely resource intensive both for the supervisors and the supervised bank. They involved numerous meetings. One bank told us that ARROW visits involved around 130 interviews.[1527] The output from the process was an overall assessment of both conduct and prudential risks and a Risk Mitigation Plan (RMP) which listed detailed issues to be addressed by the bank.[1528] We were told that supervisors adopted a box ticking approach to monitoring a bank's progress in implementing RMP actions. Peter Cummings, former CEO, Corporate Division at HBOS, told us:

    the bizarre thing is that I tell them what I am doing and it gets fed back to me as 'this is what we want you to do' [...] If they see me doing something about advance portfolio management, that is a tick in the box. If they see me doing something about a programme or a project about operational risk, and I set up a project management team to manage the operational risk project, and so on, that is a tick in the box for them. [1529], [1530]

927. Andrew Bailey has suggested that a tick-box culture amongst regulators meant that so long as firms complied with the rules, they were allowed to continue with practices that led to poor standards.[1531] Furthermore, witnesses suggested that an emphasis on rules may have encouraged gaming by banks. Michael Cohrs told us:

    I think I can take any rule and, given enough time, there would be a way around it, or I could show you how banks, in the past, have gotten around it. It does not matter how simple the rule is.[1532]


928. As was evident from our Fourth Report, the FSA's engagement with banks, even at Board level, suffered from an approach that devolved too much of the relationship to junior staff. Even for large complex banks, substantial responsibility was devolved to junior and inexperienced FSA staff.[1533] Carol Sergeant, told us that:

    in the lead-up to the crisis, we were being dealt with by very junior people. The senior management at the FSA never really darkened our door and, frankly, only when we actually asked them to come. So we would have an extraordinarily junior person who would come and present to the board and who really could not cope with the kind of challenges and questions that came from the board.[1534]

When asked what the senior people at the FSA were doing, Ms Sergeant responded: "I have no idea."[1535]


929. Witnesses also suggested that the FSA suffered from insufficient expertise amongst its supervisory staff. Carol Sergeant said that she had dealt with "extremely inexperienced people."[1536] A former bank supervisor at the Bank of England said that at the point of the transfer of banking supervision from the Bank of England to the FSA in the late 1990s, there had been a hollowing out of supervisory expertise resulting from a decision to "let go, before the transfer to the FSA, supervisors reaching or over 50 years of age".[1537]

930. A major bank suggested that the FSA had trouble attracting talented staff because it did not have the long tradition and status to be able to attract and retain the same depth of staff talent as the Bank and the Treasury, who were able to attract the brightest and the best "in part because of their status in society and their heritage and also because of the opportunity to work on the big issues impacting the UK".[1538] Furthermore, they told us that a focus by the FSA on consumer issues in its early years "would have been less interesting to those attracted to working on broader policy issues".[1539]


931. 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.

932. 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.

Real-time supervision


933. The Financial Services and Markets Act 2000 (FSMA) establishes an overarching framework for UK financial services legislation and regulation. It gives powers to the Treasury to make secondary legislation and gives the FCA and the PRA powers to make rules and guidance for firms within the scope of the FSMA regulatory regime. As part of the recent regulatory reforms, FSMA has been amended through the Financial Services Act 2012. FSMA sets out the high level 'Threshold Conditions' that banks must meet at all times in order to be permitted to carry out to regulated activities.[1540] The PRA and FCA have regard to a number of 'regulatory principles' set out in FSMA. The PRA has set out its approach to supervision in its Approach to Banking Supervision publication[1541], and the FCA has outlined its approach in its Journey to the FCA.[1542]

Box 16: Principles and rules in regulation

The now defunct FSA was widely criticised for adopting a box-ticking approach to regulation based on countless rules rather than exercising judgement based on overarching principles.[1543]

The new regulators have pledged to adopt a new approach. The FCA's Industry Guidance states that it is "committed to making a decisive shift towards more principles-based regulation, including making the regulatory architecture more principles-based, with greater emphasis on high-level and outcome-focused rules".[1544] Similarly, Andrew Bailey described the new PRA approach as one where "supervisors concentrate on the biggest risks to our statutory objectives posed by the firm, rather than pursuing a myriad of issues that in some cases resulted in the FSA being more like an internal audit function than a regulator".[1545]

However, pledges to move away from box-ticking are nothing new. At the FSA's formal launch in November 2001, its then Chairman, Sir Howard Davies, said:

"We need to alter the way we deal with firms. We don't want—and they don't want—a box checking routine. Our risk-based approach should ensure that in future, when we visit a firm we have a clear purpose in doing so."[1546]

Julia Black wrote that, at least in theory, "The use of Principles, rather than reliance solely on more detailed and prescriptive rules, has been a feature of the regulatory regime for financial services since 1990".[1547]

934. Both regulators intend to adopt a judgement-based approach in future. The scale of the change in approach that is needed to deliver judgement-based supervision should not be underestimated. We asked for written evidence from banks on the approach of the regulators. Taken together, their evidence gives us pause for thought. Although our evidence was collected prior to the formal creation of the FCA and PRA, the FSA had at that point adopted an internal structure under which it was operating prudential and conduct supervision from within separate parts of the organisation (the Prudential Business Unit (PBU)) and Conduct Business Unit (CBU)). Banks appeared to be concerned that old habits persist. A major UK bank told us that it would encourage the new regulators:

    to devote more effort to understanding the big strategic goals of the organisation, rather than focussing on the micro level details. Many meetings are scheduled which focus mainly on the latter.[1548]


935. The PRA has stated its intention to adopt a judgement-based approach to supervision, focusing on major risks to their objectives. The PRA explains that its approach:

    relies significantly on judgement. [...], in particular, supervisors need to decide which risks are the most material and must be pursued. A judgement-based approach is necessary in a forward-looking regime, where the future state of the world is inherently uncertain.[1549]

To support this new judgement-based approach, the PRA has developed a risk framework, illustrated below. There will be three key elements to the framework. First, supervisors will assess the potential impact of a firm, both in the event of failure, and the potential for firm failure to cause disruption to critical financial services, and through ensuring that the firm's behaviour does not contribute to stress in the financial system through risky behaviour. Second, supervisors will assess risks to the firm arising from the external environment in which it operates and risks arising from its business model. Finally, it will assess the strength of mitigating factors which offset risks posed to the firm, such as the effectiveness of management and governance; risk controls; and the adequacy of capital and liquidity. The supervisors will take account of the resolvability of a firm. Assessments will be aimed at identifying the major risks to the firm. Firms will be subject to assessment work on a continuous cycle, with the PRA regularly updating its overall view of a firm, the risks it faces and the risks it poses. The frequency and intensity of the PRA's work will increase in line with a firm's potential to create disruption to the wider financial system in the event of failure. [1550] The PRA will not operate a zero failure regime.

The PRA's risk framework
Gross risk
Mitigating factors
Potential impact
Risk context
Operational mitigation
Financial mitigation
Structural mitigation
Potential impact
External context
Business risk
Management and governance
Risk management and controls

Source: Bank of England, The Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p12

936. In reaching judgements, the PRA intends to be forward-looking, meaning that it will apply stress tests based on plausible and extreme scenarios. The PRA recognises that its judgements will sometimes be wrong. This may particularly be the case if judgements are made about events whose outcomes are uncertain or that are yet to happen. The PRA's Approach to Banking Supervision document notes that:

    The PRA's supervisory judgements are based on evidence and analysis. It is, however, inherent in a forward-looking system that, at times, the supervisor's judgement will be at variance with that of the firm. Furthermore, there will be occasions when events will show that the supervisor's judgement, in hindsight, was wrong.[1551]

937. In its Report, The FSA's Report into the Failure of RBS, the Treasury Committee noted that the PRA's use of judgement-based regulation in the future could, at times, lead to the appearance that the PRA was acting as a shadow director and raised an expectation that the PRA examine how it will minimise this risk and publish its findings.[1552] John Kay has cautioned against supervisors acting as shadow managers, arguing:

    Supervision involves a form of shadow management; but it is almost inevitable - and wholly inevitable in the financial services industry - that shadow management will be at a disadvantage to the real management in terms of the competence of its staff and the quality of information available to it.[1553]

A joint response from both regulators to the Treasury Committee's Report stated that:

    In carrying out our responsibilities we consider that, as long as we act properly within our statutory functions, the Court[s] should not classify either the PRA or FCA as a shadow director of regulated firms.[1554]

The response further drew attention to the PRA's statement in its Approach to Banking Supervision document that the responsibility for running a bank rests firmly with its management and board, stating:

    [...i]t is the responsibility of each firm's board and management to manage the firm prudently, consistent with its safety and soundness, thereby contributing to the continued stability of the financial system.[1555]

938. An example of how judgement-based supervision will be applied is in the assessment of a bank's asset quality, including its approach to asset valuations. Appropriate asset valuations are important in determining the adequacy of a bank's capital (which needs to be able to absorb losses arising from a deterioration in asset values). They are also important for assessing liquidity, where the realistic valuation of assets held in a bank's treasury portfolio is necessary for ensuring that the bank is able to raise sufficient cash when required to meet obligations. One of the deficiencies in prudential regulation in the lead up to the financial crisis was a failure to ensure that asset valuations were appropriate. This proved to be a particular problem for certain asset classes, such as portfolios of commercial loans, and in relation to asset backed securities, where there was a failure to understand the inherent risks in the product. In our Fourth Report we noted how one of the FSA staff responsible for HBOS told us that the FSA's approach was one: "that was nowhere near sufficient to be able to get to grips with the actual quality of the underlying assets within the book."[1556] A failure to adopt a forward looking approach to asset valuations was reflected in inadequate stress testing. Michael Foot told us:

    by the time you got to the end of 2008, I suspect that the stress testing that the FSA were requiring of their firms pretty well included the end of the universe, which was good, but before that they were not doing so. They were in a paradigm that said, "We have all this value-at-risk data and we have this experience of this, that and the other; let's stress the housing market by watching prices fall by 20 per cent or whatever." Actually, when things went wrong, they went wrong in a much worse way, partly because everybody-regulators included-underestimated the extent to which asset classes were correlated.[1557]

939. The PRA intends to take a more pro-active approach to asset valuations. The PRA's Approach to Banking Supervision notes that:

    forward-looking stress testing, tailored to firms' particular risks, plays an important part in the PRA's judgements about a firm's financial soundness in the presence of inevitable uncertainty about future risks. Stress tests cover the quality of lending portfolios, the robustness of asset valuations and provisions and the liquidity and valuations of trading portfolios.[1558]

Andy Haldane suggested to us that one approach that supervisors could take to the valuation of assets would be to conduct spot checks on assets to see if they are behaving in the way expected:

    I am attracted to the idea of what you might call a spot-check approach to supervision and regulation, which is not to have an army of regulators and supervisors peering down every rabbit hole, looking for problems, but instead to pick an asset [...] at random, through a spot check, and assess whether it is doing all that it says on the tin.[1559]

940. If the regulators find deficiencies in valuations of certain assets classes, they will need to ensure that the bank takes remedial action. They may heighten the intensity of supervision through, for example, additional capital requirements or restrictions on the business until deficiencies have been addressed. In the event of a failure to take proper remedial action, the regulator may take enforcement action against the firm or individuals. As we explained in Chapter 6, the Commission is proposing that a Senior Person will be held responsible for each risk area in a bank. The appropriate person will be held responsible for addressing any deficiencies in the approach to valuations. For example, if these are in treasury asset valuations, the Treasurer may be liable.

941. 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.

942. 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.


943. In its Journey to the FCA, the FCA states that:

    The new approach will be underpinned by judgement-based supervision. This means that we will be making supervisory judgements about a firm's business model and forward looking strategy, and will intervene if we see unacceptable risks to the fair treatment of customers.

In order to assess conduct risks, the FCA has replaced the failed ARROW framework with a Firm Systemic Framework (FSF). Through the FSF it will "assess how firms manage the risks they create and identify the root causes of what leads to these risks". It will also seek to understand consumers' actual experiences of dealing with firms. The assessment will draw on business model analysis to identify the key issues which firms need to address.[1560] As with the old ARROW approach, the assessment will take place through interviews between supervisors and the firm, and will result in a letter sent to banks identifying the key risks and accompanied by a risk mitigation programme. According to the Journey to the FCA document, there will be some differences between the FSF and ARROW (such as prioritisation of actions by the firm and fewer risk mitigation points), but the extent to which the old ARROW approach has been truly jettisoned remains unclear.

944. Evidence suggests that changing approach to a new, judgement-based approach may prove challenging for the FCA. One of the challenges will be to move away from collecting and analysing large quantities of low level data. Douglas Flint told us:

    There is still a tremendous amount of data capture, which is incredibly low-level detail. I hope that as we get into the new regime we can use a much more interactive relationship to get to the forest and away from the twigs on the branches of the trees.[1561]

Effective data gathering appears to be a particular challenge for the conduct regulator. Commenting on data gathering under the arrangements established by the FSA for prudential and conduct regulation before the formal transition to the new regulatory structure, one bank told us:

    our experience is that the Prudential Business Unit is now making good progress on scoping information requests and channelling them through the Supervision team. We look forward to the Conduct Business Unit taking a similarly business focused approach.[1562]

Another bank told us:

    There is evidence that the number and volume of requests has increased considerably and this is particularly in the context of the Conduct Business Unit at the FSA. Clearly there is an emerging agenda, as described in the "Journey to the FCA" document and this coupled with a higher frequency of idiosyncratic and thematic visits and information request has contributed to the increase. We expect the frequency of requests to increase.[1563]

945. A further challenge that makes the analysis of data more difficult is the weak IT systems that the FCA has inherited from the FSA. The FCA has noted the need for significant investment in its IT capability in its 2013/14 Business Plan, without which, there is an increasing risk that its systems will not be fit for purpose to enable it to meet its statutory objectives.[1564]

946. 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.

Products supervision

947. The FCA will have new, more wide-ranging powers to intervene in financial products under the Financial Services Act 2012. These include the mandate to make rules to ban products that pose unacceptable risks to consumers, subject to consultation, and to make temporary product intervention rules where the delay involved in consultation would prejudice consumer interests.[1565] Jon Pain described these as "a fairly powerful series of tools to deploy."[1566]

948. Some remarks made by successive Chief Executives of the FCA and its predecessor body, the FSA, are unlikely to encourage constructive engagement with the regulated community, widely held to be much-needed, as discussed further below. In the aftermath of the financial crisis, Hector Sants is reported as saying:

    There is a view that people are not frightened of the FSA [...] I can assure you that this is a view I am determined to correct. People should be very frightened of the FSA.[1567]

More recently, Martin Wheatley has reinforced this view, stating that the FCA is "being given the power to shoot first and ask questions later."[1568] There are risks in such an approach, not only to the relationship between regulators and firms but also in that it may discourage banks from innovating in new products, to the detriment of consumers. Andy Haldane told us:

    It is important [...] not to overshoot. We would not want to put ourselves in a position in which banks were sufficiently scared and scarred not to wish to innovate-to bring new financial products-for fear of, ultimately, being caught out down the road for having produced something that is not quite doing what it says on the tin.[1569]

949. Although the FCA will have powers to intervene in products, it will not pre-approve products. According to the Journey to the FCA document, this would "require a marked increase in regulatory resources" and "it could also lead consumers to assume that all products had been endorsed by the regulator were therefore 'safe'."[1570] Some witnesses felt that a form of kite-marking would, however, be desirable to remove the risk of judgements being made about a product's suitability by the regulator. Douglas Flint told us:

    some kind of product regulation that creates kitemark products is worthy of exploration. There needs to be some kind of safe harbour. If a product has been designed to a regulatory-approved specification and if the sales standards and practices designed for that product are followed, in terms of identifying to whom it should be sold and how it should be sold, there ought to be a confident belief that that works. The industry deals with situations where it has been challenged that it has failed in its sales practices over a long period of time. We have to try and find a way for our own, and society's, protection to get to these issues earlier, and the public can be confident that we have a suite of products that do what they say on the tin.[1571]

Asked whether kite-marking was about providing a safe harbour from the perspective of the firm or the consumer, Stuart Gulliver told us:

    From both. We have to think, "What in 2023 that we sold today in 2013 will be deemed to have been inappropriate?" That leads to all sorts of issues around financial exclusion, if you think about it, because it means firms back away. We hope that the FCA can provide kitemark-stamped products that, yes, protect the industry, because they protect the consumer and cannot be unpeeled in 10 years' time.[1572]

950. Witnesses suggested that the approach of the FCA needs to become less retrospective and that it should deal with issues proactively. Douglas Flint told us:

    The final thing that I will say [...] is about the need for more proximate interaction. We are dealing today with issues like PPI and interest rate swaps, where we are determining that it may not have been as it should have been for a very long time. We have to try to find a way, between the industry and the supervisor regulators, of being much quicker to identify that there is an issue and fixing it, rather than saying we have to compensate for something going back a significant number of years, because that makes it very difficult to think about what might happen in the future that you should have known about today.[1573]

951. Sir Mervyn King agreed that specifically in the case of mis-selling:

    if the conduct regulators are going to launch an accusation of mis-selling, they need to do it much closer to the date when the product has been "mis-sold". If it is possible to conceive of mis-selling a product, it ought to be possible to do it pretty close to the time when the product was sold [...] the banks have a point in being exposed to uncertainty for an indefinite period on an unknowable scale, when the regulators can simply deem something to be mis-selling.

952. The FSA has itself acknowledged that the way in which they handled past market failures was inadequate:

One of the key lessons we have learned from market failures, such as PPI, is that it can be much more effective to intervene early, to pre-empt and prevent widespread harm from happening to consumers in the first place rather than clearing up after the event.[1574]

Paul Geddes, Chief Executive of Direct Line Group, RBS, told us that a failure by regulators to be pro-active could contribute to customer detriment:

    Early engagement at a very senior level to sort these things out immediately is absolutely imperative, because in the elapsed time, for reputation, it is expensive, it is bad for the customer and it is bad for trust.[1575]

A bank indicated that it did not have confidence in the FCA delivering an approach that is not backwards-looking:

    While we support the goals of the FCA to ensure adequate protection for consumers of financial services and their intention to be more forward-looking in their approach, we remain concerned that it will continue to be too backward-looking and disproportionate in respect of the costs of its interventions relative to the outcomes for customers that it seeks to achieve.[1576]

953. 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.

954. 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.

955. The Financial Services and Markets Act (FSMA) gives designated consumer bodies the right to make a "super-complaint" to the FCA where they consider that there are features of a market for financial services in the United Kingdom that may be significantly damaging the interests of consumers. HMT has responsibility for designating those consumer bodies. The FCA is required to respond to super-complaints within 90 days. The Commission heard how the regulators failed to deal with concerns about PPI adequately in the past. The Citizens' Advice Bureau told us they raised concerns about PPI as early as 1995 [1577] and yet it was over a decade later that any significant action was taken by the authorities to address the problem. The Commission heard that the way in which the FSA's response to PPI was centred around individual complaints was inappropriate.[1578] Asked whether there was a need for a new form of collective redress, Natalie Ceeney told us that:

    The FCA to be, and the FSA for the past couple of years, has that power. There was a power to do that even as early as 2008, which was essentially what we were calling for. The issue is that it has not been widely used. For example, the FSA has a power called section 404 of the Financial Services and Markets Act that allows it to create an industry-wide scheme to give compensation to a large group of customers.[1579]

956. The FCA has produced draft guidance for designated bodies on how it will respond to super-complaints in future.[1580] This includes setting out how it proposes to deal with the complaint, explaining whether it has decided to take any action, and if so, what action it proposes to take, with reasons. Possible outcomes range from initiating a consumer redress scheme or deciding that no action should be taken. The FCA has stated that it will make the process straightforward for the organisations that may submit super-complaints.

957. 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.

Supervisory relationship with banks

958. We noted earlier in this chapter how engagement between the FSA and banks had been conducted at an inappropriately junior level with a focus on low level detail instead of material risk issues. Recognising this deficiency, both of the new regulators have stated that there will be more senior-level engagement in future. The PRA has stated that future engagement with banks will be at an appropriately senior level, noting that "major judgements and decisions will involve the PRA's most senior and experienced staff and directors".[1581] The FCA has said that it will "act more quickly and decisively and be more pre-emptive in identifying and addressing problems before they cause harm, with our senior staff involved in supervision issues at an earlier stage."[1582] The PRA will focus on material issues in its engagement with firms.[1583] The FCA has said that it will "focus on the biggest problems firms need to tackle."[1584] Douglas Flint appeared to support this approach when he said that regulators should, in the senior-level discussions:

    Focus on the big issues. If you are talking to the board, you should be talking about the issues that are at board level, which are the big structural issues: the risk appetite, culture, the quality of people, succession planning.[1585]

959. Andy Haldane told us that discussions at an appropriately high level can be particularly useful in ensuring that the senior management of banks understand their business properly. He told us:

    I think back to the approach to supervision and regulation when it was last done in the Bank of England. At the centre of that approach was a conversation at the highest level between the Governor of the day and the chief executive or chairman of the bank. That conversation was effectively a spot check on the adequacy of the senior management in understanding its business.[1586]

960. An appropriately senior level of engagement which focuses on material risk issues will be important in successfully delivering a judgement-based approach to supervision as it will involve making judgements that banks sometimes disagree with, and in many cases, that banks do not like. Andrew Bailey told us that the regulators "accept that in a judgement-based approach to supervision, there will be disagreement. We don't seek disagreement for the love of it, but it is part of what we do."[1587]

961. In order to ensure an appropriate level of engagement it will be essential for supervisory staff to escalate issues appropriately. Michael Foot explained the challenges faced by supervisors in this regard:

    The great trouble that Andrew Bailey or somebody like him will face is this. He will have a relationship manager [...] for a major group, and that individual has a number of people working for them. They have access to credit experts, trading experts and operational risk people and to one or more 'grey panthers', who provide the external view. That group of people have to come up with a judgment that is basically sound about the risks and the opportunities, and then the senior people have to take that and form the right judgments. [...] I suspect and hope that Andrew and his senior people will spend more time facing towards the industry, talking to them and being involved in this, but because of the sheer scale of the operations, there has to be a very clever process for bringing this together.[1588]

962. In adopting their new approaches, the regulators will need to establish a relationship of trust with banks so that senior level discussions are open and frank. Michael Cohrs, Member of Financial Policy Committee, Bank of England, told us:

    I do think it is important to have a relationship between the regulator and the senior management of a bank. It is a place where this country has not done a good job, because I had a feeling that if I went to my UK regulator with a problem or an issue-this is a personal opinion-it spiralled out of control. The next thing I knew, there were 20 guys from the regulator in, and it was on the front page of The Times.[1589]

963. There are signs that the approach of the conduct regulator may not yet be conducive to a constructive relationship. A banker told us:

    the tone of dialogue with staff at the FCA is often adversarial rather than that of a regulator with a shared agenda.[1590]

964. Banks also need to do their part in creating a constructive supervisory relationship. The regulators' relationship with banks has been marred by banks resisting decisions they do not like or lobbying for decisions that are favourable to them. The FSA has noted that when it was investigating PPI:

    We received considerable resistance from firms to the changes we suggested and requested; firms were more interested in the major revenue stream PPI offered than in improving standards and enforcement penalties alone were not enough to change behaviour. The resistance from firms has been a factor in us adopting a tougher penalties regime in 2010.[1591]

This behaviour appears to continue. Andrew Bailey told us:

    What do you get for Christmas, as a regulator? You get a request to change somebody's model before the year end. What is all this about? What it is all about, essentially, is fitting your model to deliver an overall capital ratio that you think is the one you want to tell the world you have got. I do not fall for the fact that they all come in at the same time of year. There is a distinct seasonality to this.[1592]

Such behaviour will need to change. The PRA Approach to Banking Supervision states that "firms should not [...] approach their relationship with the PRA as a negotiation."[1593]

965. 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.

Special measures

966. One of the main themes to emerge from our work is that many of seemingly discrete failings within the banking sector in recent years, often characterised distinctly as prudential failing or conduct failings, have common roots. In some of the evidence we took from banks, it was a notable feature that several apparently unrelated failings could be attributed to common weaknesses, many having their origin in a failure of standards at the most senior levels of the bank concerned. Numerous incidents across a wide range of business areas within a bank may be indicative of wide-scale failings in leadership, risk management and behaviour. As Tracey McDermott told us:

    The other thing that I would say is a series of red flags—it was demonstrated by UBS, but also by some other firms—is a series of serious failures in different bits of the business. Some of them may not individually be massively significant, but what does that say about the culture if people in quite disparate parts of the organisation can basically get around the rules?[1594]

967. Both regulators have emphasised the importance of the culture and overall approach by banks. The PRA has stated that it expects "firms to have a culture that supports their prudent management".[1595] The FCA has indicated that it expects firms "to base their business model, their culture, and how they run their business, on a foundation of fair treatment of customers."[1596] The standards and culture of a bank are a matter for the bank itself, and above all its Board. They cannot be imposed by regulators. As Michael Cohrs said:

    We would be mistaken if we thought that the regulators can go into an organisation and impose a culture that they would like. The organisations themselves are going to have to do it, and we have to use incentive tools to create the right outcomes.[1597]

968. The PRA and the FCA have each designed their own individual approach to assessing governance and culture in firms. The PRA assesses governance and management, and risk management and controls, through its risk framework.[1598] This draws on the FCA's findings on key conduct risks (such as money laundering) where they are relevant to the PRA's objective. An output from the PRA's risk assessment is to assign a bank to a Proactive Intervention Framework (PIF) stage which determines the ongoing intensity of supervision of a firm and regulatory actions. Further information on the PIF is provided in Box 17. The FCA reviews governance and culture as part of its Firm Systemic Framework, which is designed to assess a firm's conduct risk.[1599] The FCA does not have the equivalent of the PIF. Where either regulator identifies specific concerns through its routine risk assessment, or if issues of concern come to their attention from other sources, they may decide to conduct further action.

Box 17: Proactive Intervention Framework (PIF)

A bank's PIF stage is derived by the regulator's assessment of a bank through its risk framework. The stage indicates a firm's proximity to failure and determines the ongoing intensity of supervision. Examples are as follows:

·  PIF Stage 1 (Low risk to viability): The bank is subject to normal supervisory risk assessment process and actions.

·  PIF Stage 2 (Moderate risk to viability): The intensity of supervision increases. There may be additional reporting requirements and/or use of information gathering powers. The firm is required to address deficiencies over a set period.

·  PIF Stage 3 (Risk to viability absent action by the bank): The regulator may require: a change to management and/or composition of the board; limits on capital distribution (including dividends and variable remuneration); restrictions on existing of planned business activities.

·  PIF stages are not disclosed publicly.

969. In the US, the regulator of national banks (the Office of the Comptroller of the Currency (OCC)) may undertake informal enforcement action in response to identifying serious failings within the banks it supervises. Further information on the US approach is provided in Box 18.

Box 18: The US Approach

Prior to the OCC entering into formal enforcement action, the OCC has a number of informal actions available to it. These range from:

·  a commitment letter: this is signed by the bank's board, reflecting specific written commitments to take corrective actions in response to problems or concerns identified by the OCC in its supervision of the bank;

·  a Memorandum of Understanding (MoU): a bilateral document signed by the bank's board of directors on behalf of the bank and an authorised OCC representative. An MoU is drafted by the OCC and in form and content is similar to formal enforcement action. It legally has the same force and effect as a Commitment Letter.

·  Safety and Soundness Plan: the OCC issues to the bank a notification of failure to meet safety and soundness standards and requires the submission of a Safety and Soundness Compliance Plan. The Plan must include a description of steps the bank will take to correct deficiencies and the time within which each step are to be taken. If approved by the OCC, the Plan functions as an informal enforcement action.[1600]

970. 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.

971. 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. The regulators already have a power under section 166 of FSMA to commission a "skilled persons" report on a particular aspect of a bank's business. The benefits of this tool can be blunted when the "skilled persons" lack genuine independence, a problem highlighted by the report carried out by an audit firm into risk management in HBOS, which we considered in our Fourth Report.[1601] 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.

972. 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.

973. 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.

Supervisory resources


974. If regulators are to make their contribution to raising standards in banking, they need experienced and talented staff. The delivery of a judgement-based approach will, in particular, require senior and experienced staff who are able to deal confidently with the banks they regulate. Martin Wheatley acknowledged that changes are required to the FCA's staff in order to deliver the new judgement-based approach:

    clearly we need either to upgrade or train our people. We need senior people who have a few more battle scars and are more prepared to use their judgement.[1602]

975. Michael Foot told us that finding and retaining individuals to deliver the approach may be difficult:

    the main difference between regulation and supervision is over the implicit requirement that supervision has to exercise judgement. I am very comfortable with what Andrew Bailey has said about how the PRA will try to operate this, but we all have to realise - I am sure that he realises - that the kind of skill sets you require to exercise that judgement are hard to find. We all know that regulators here are quite difficult to keep."[1603]

The difficulty that the FSA had in retaining staff is noted in the FCA's Journey to the FCA document, which says that:

    we face many challenges; for example, a significant number of people are leaving the FSA after being here four or five years, as we are often seen as an industry training ground.[1604]

The need for high quality staff may be particularly important in supporting real time intervention by the FCA to protect consumers from harmful products. Carol Sergeant noted that the use of the product intervention powers will require:

    courageous people. [...] You have to be courageous to come in and say, "I am going to stop that product. I don't like it."[1605]

976. A particular challenge for the FCA in attracting talented staff may be the nature of its work, and the continued tendency towards low level analysis and extensive data gathering described above. As Douglas Flint explained:

    If the role of the supervisor is much more to be high-level, understanding of the risks, and dealing at a senior level in organisations, that is a much more interesting career than the kind of much more minute data gathering, sticking it into a matrix and determining whether it comes out right. I think if the intellectual quality of the role is higher you will get better people.[1606]

As Michael Foot also pointed out, the nature of the FCA's work may lack the appeal of more intellectually challenging roles:

    intellectual challenge is one of the most exciting things you can offer people in the regulatory sphere. Unfortunately, being part of a working party in Basel or wherever tends to have more intellectual appeal to it than trying to sort out the plumbing in RBS's IT problems, for example. That is unfortunate. However, that intellectual appeal and approval within the narrow circle of regulators are the things on which you can build a career.[1607]

977. The PRA will also need experienced supervisors in order to deliver its new approach. The PRA's Approach to Banking Supervision document notes that: "the PRA will have a larger proportion of more experienced and senior supervisors compared with the past."[1608] The PRA may find it easier to attract the most talented staff than the FCA. This is because the prudential regulator will benefit from the broader range of expertise from within the Bank of England, which may enable it to attract the most talented staff in a way that was not open to the FSA, and is not open to the FCA.[1609] The PRA should benefit from the long established culture of the Bank of England. A banker told us:

    Good judgement comes both from intellect and experience and experience is hard to fast track. That is part of the distinction between the Bank, the Treasury and the FSA. Those we deal with at the Bank and the Treasury typically have long service in both institutions and have considerable experience of the issues they are faced with.[1610]

Andy Haldane made a similar point:

    I hope that bringing supervision into the Bank of England will broaden the base of human resources-human capital-that can be deployed in line supervising banks. On average that makes for somewhat more experienced supervision of firms than we have had over the last 10 to 15 years.[1611]

The PRA's Approach to Banking Supervision document notes:

    staff have the opportunity to work in other parts of the Bank of England as a way of broadening their knowledge and management experience, and similarly the PRA will be open to staff moving from other parts of the Bank.

It also notes that: "the Bank's recruitment, talent management and career development programmes have been extended across the PRA" and that the PRA offers "compelling careers centred around intellectual challenge and excellence, and a commitment to public service through its public policy objectives".[1612]

978. Andrew Bailey noted that since supervision moved to the FSA from the Bank of England, "there had been a substantial divergence in culture between the two organisations".[1613] Change will not be achieved overnight. As Sir Mervyn King has pointed out:

    focusing on the judgments that are needed does not require vast numbers of people, and my instinct would be true in the Bank of England too, that you do not need vast numbers of people, but you need the right people with the right focus and commitment, and that is going to be a challenge to us and it will take time to get there.[1614]

979. The PRA staff should benefit from the Bank of England's good record of providing rewarding careers that compensate for lower pay than the financial services industry can offer. Andrew Bailey told the Treasury Committee:

    I can tell you [...] that this is hugely difficult work that we do, but it is hugely enjoyable, frankly, and we need people who have got that enjoyment of that combined with clearly a level of remuneration which says, "That is a reasonable combination for me". It is not easy to find, but we have had a good record, I think, in the Bank of England over the years of finding those people and keeping enough of them.[1615]

Michael Cohrs echoed this view in his evidence to us:

    I would strongly encourage you to listen to Mervyn King's speech that he gives to graduates who come into the Bank or people who are thinking about what to do. He gives a very compelling speech about being in a career in bank regulation. He talks about a career, which is something, to be blunt, that you do not see financial institutions talking about. They talk about money, about a year or about two years, but Mervyn gives a very compelling speech about a career.[1616]


980. In Chapter 3, we set out how the history of banking failures repeats itself. It is therefore important that regulators, like bankers, try to learn the lessons of history. Christine Downton, founding partner of Pareto Partners, told us that "the problem in the recent crisis was once again the regulators lost the plot".[1617] She suggested that:

    regulators should be trained more in the history of financial crises. We need to add to the training that regulators generally get. To have case studies of a range of financial crises would be an extremely useful addition to their training. [...]Financial crises don't often happen immediately one after the other: there tends to be a lag while those people who learnt lessons move out of the industry. I think we have seen that time and time again. [...] the only thing I can suggest is that people are required to have a greater grasp of the conditions in which financial crises occur. [1618]

Andy Haldane argued that catching financial crises relies on a lengthy sample of past experience, as a full crisis may last 20 to 30 years, with a systemic crisis only occurring once or twice a century. One of the secrets of making the new supervisory approach work will be the accumulated experience of supervisory staff.[1619]

981. We heard from Lord Turner and Martin Wheatley that ensuring supervisors learn the lessons of past financial crises has not formed part of the training programme for supervisory staff.[1620] Martin Wheatley told us that while the FSA had covered recent crises in its training, this only spanned the last five years:

    We have built into our training certainly the lessons from the recent crisis-the past five years. It is an interesting point as to whether we should take a more expansive view and look at the repeated crises over a longer time period, but certainly the past five years have been very much built been into our approach.[1621]

Lord Turner was in favour of increasing awareness amongst supervisors of historical events:

    I will now encourage the PRA in particular to do that and to say, "Is there a history element of it?" You are quite right that there are a series of banking crises which have extraordinarily common features. Too much lending to commercial real estate-which goes up in value, which then encourages more lending and, for a period of time, makes people feel that the risks have disappeared-is one of the most common features of everything from the Scandinavian crisis of the early 1990s to the Japanese, etc.[1622]

982. 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.


983. Regulation is often viewed as a free good. It is not; it has both direct and indirect costs. These are ultimately borne by consumers in higher prices or services forgone. Banks pointed out that there are very significant costs in terms of both compliance and management time, in addition to the annual fees paid to the regulator. Routine compliance and management costs were estimated to be as high as £100m for a large bank, with additional costs for regulatory projects increasing the amount by up to seven times.[1623] Costs have been rising as a result of the very significant increase in the number and scale of data requests (as outlined above), some of which require bespoke IT reporting solutions. The Bank of England has said that it its "intention is that the PRA will operate, in the medium term, at lower cost than the equivalent part of the FSA".[1624] Sir Mervyn King has stated:

    I believe that we can operate prudential supervision at lower cost than hitherto by reducing the burden of routine data collection and focussing on the major risks to the system. [...]Targeted and focussed regulation, allowing senior supervisors to exercise their judgement, does not require ever-increasing resources.[1625]

984. As discussed above, it remains to be seen whether savings from a reduced reporting requirement will be achievable given the increasing demands of European regulations. Furthermore, it is notable that the recently published combined Annual Funding Requirement (AFR) the PRA and FCA for 2013/14 is some 15 per cent higher than the AFR for the FSA in the previous year. The increase reflects in part a rise in the cost of front-line supervisory staff resulting from the move to a judgement-based, forward-looking and risk-focused approach to supervision, but also costs arising from investment in IT infrastructure and an increase in the cost of support services (such as HR functions) following the implementation of dual regulation, which are expected to reduce over time.[1626]

985. 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.

A role for senior bankers?

986. As well as a need to recruit and retain talented and committed staff, delivering a judgement-based approach will require the regulator to keep up to date with developments and innovations in the banking industry. The FSA had access to banking industry advice through the Financial Services Practitioner Panel (FSPP), with whom it consulted on new policy initiatives. While the FSPP provided a source of advice to the regulators, it also represented the interests of regulated firms, creating potential conflicts of interest. Both the FCA and the PRA have similar arrangements under the new statutory framework.[1627]

987. The most effective way to ensure that regulators have access to independent and unconflicted advice is to bring the expertise in-house. One way to do so is to recruit individuals with banking expertise. Regulators face challenges, however, in attracting and retaining experienced staff with financial services industry expertise because they cannot pay the same salaries as the private financial services sector. In order to address the need for banking expertise, when supervision was conducted by the Bank of England before 1998, the accounting firms operated secondment programmes to the Bank's Banking Supervision Division.[1628]

988. Senior individuals in banks are best placed to understand where the major risks lie and are most likely to crystallise as banks develop new products and engage in new activities. The skills of individuals who have developed the ability to understand and gauge these risks are not, however, currently harnessed by the regulator in any formal way. A banker told us:

    There ought to be a way to bring people in from the industry to the FCA and the PRA, both at mid-career and possibly at the end of career by way of public service to an industry that has been good to individuals.[1629]

989. Banks will continue to contribute to systemic risk and senior bankers owe a duty beyond the firm. Their enjoyment of high salaries is derived in part from structural features in the banking market, including the existence of an implicit taxpayer guarantee which means that bankers can receive exceptionally high rewards for taking a low level of personal risk. Douglas Flint and Stuart Gulliver both agreed that it would be reasonable for those who are the best placed to advise on how to handle risk discovery to give something back to society towards the end of their careers.[1630] Douglas Flint said that he would give the question of whether he would be interested in joining a team of like-minded people to assist the PRA upon his retirement "favourable consideration".[1631]

990. Senior bankers owe an enduring duty to mitigate systemic risk. The best gamekeepers are usually former poachers. The most senior individuals in banks, such as Chairmen and Chief Executives, should be the best placed to understand where risks lie within banks as new products are developed and banks engage in new activities. When they no longer work for the bank, such individuals are well-placed to give their views to supervisors on regulatory policy developments and supervisory judgements, such as the risks presented by new products and within bank business models.

991. 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.

Regulatory Framework


992. The regulatory framework is increasingly governed by international rules and regulations. The foundations for the regulations are non-statutory Basel Accords, which are underpinned by national legislation and rule-making.[1632] Basel II is being replaced by Basel III, which is being implemented in the UK through the CRD IV Directive and Capital Requirements Regulations. Basel III imposes higher capital requirements and introduces a new minimum 3 per cent leverage ratio and new liquidity requirements. Basel III continues to bear, however, many of the flaws of Basel II and adds further layers of complexity. Basel I was 30 pages long, Basel II came in at 347 pages, and the documents that make up Basel III add up to 616 pages. For a large complex bank, there has been a rise in the number of calculations required from single figures a generation ago to several million today. The number of estimated parameters required to calculate risk in a large bank's trading and banking books could now run to several million.[1633] Michael Foot told us:

    I have to say that I think Basel III is somewhat better than Basel II, but I don't for a minute think that the regulators have learnt the lesson.[1634]

Sir Mervyn King pointed out that:

    the more detailed the Basel regime has become, inevitably the more inflexible it has become. It has become inflexible in areas where actually you need flexibility, such as risk weights on mortgages.[1635]

Box 19: Liquidity and capital requirements under Basel III

Basel III incorporates both minimum capital requirements, and, for the first time in internationally-agreed regulation, minimum liquidity requirements.

The minimum capital requirements build on Basel II in using the concept of risk-weighted assets and the use of internal models is still permitted in some cases. However, the risk weights applied to trading book assets have generally been increased, alongside an increase in the minimum requirements for the ratio of capital to risk-weighted assets.

A leverage ratio requirement has been introduced which requires a minimum required ratio of capital to unweighted assets. This is a regulatory backstop which supplements the minimum required ratio of capital to risk-weighted assets.

The minimum liquidity requirements have two main elements. First, to improve the short-term resilience of the liquidity risk profile of financial institutions, there is a Liquidity Coverage Requirement. Second, to ensure that an institution has an acceptable amount of stable funding to support the institutions assets and activities over the medium term, there is a Net Stable Funding Requirement.

While Basel III imposes higher capital requirements on banks than did Basel II, important anomalies remain. For example, sovereign exposures carry a zero risk weight in cases where the sovereign is rated AAA to AA- or, at the national supervisor's discretion, in the case of domestic currency sovereign debt holdings funded in domestic currencies. Mortgage assets, which form a very large proportion of some banks' assets, are still eligible for internal rating; and there is no certainty that different banks will apply consistent weights to them.

993. In written evidence, Stilpon Nestor noted that bank boards following detailed Basel II capital adequacy measures had missed obvious risks, such as increasing gross leverage and decreasing liquidity, but that new risks were now emerging under Basel III:

    While Basel III now "catches" these particular elephants, history teaches us that there are others roaming free and undetected—and that sooner or later they will strike. Sovereign risk exposures that carry zero risk weight in the Basel III calculation of the denominator of capital adequacy are a good reminder of the dangers that lie ahead. If all banks are made to think inside the regulatory box, it is unlikely that they will catch any of these new elephants.[1636]

In addressing the problems with Basel III, Andy Haldane told us that an important step was to convince regulators at an international level to change approach. He told us:

    I have been encouraged to see, over the course of the last few months-perhaps the last six months-that there is an increasing awareness among international regulators that we may have, indeed, taken a false turn. There are moves now afoot within the Basel committee to seek ways of simplifying and streamlining, and to move to a proper, regulatory-rather than self-regulatory-edifice.[1637]

994. Basel III is a harmonisation of minimum standards which means that national regulators may impose additional requirements on the banks they regulate. Through the implementation of CRD IV and the Capital Requirement Regulations, the EU has been moving in the direction of maximum harmonisation which reduces the flexibility of national regulators. Further information on CRD IV is provided in Box 20. Michael Foot said that he was:

    strongly against any move within the EU to force complete harmonisation and not allow a country to have higher standards if it wishes. In terms of whether we should just be pushing ahead on our own, the UK is very well equipped.[1638]

Box 20: CRD IV and the Capital Requirements Regulations

·  Basel III will be implemented in the EU through the Fourth Capital Requirements Directive (CRD IV) and Capital Requirements Regulations (CRR). In the EU, a directive lays down certain results that must be achieved in Member States.[1639] National authorities have to adapt their laws to meet these goals, but are free to decide how to do so. Directives therefore allow greater levels of national discretion. Regulations become law in Member States as soon as they are passed by the EU authorities and become legal binding on a par with national law.[1640] This removes the major sources of national divergence (from different interpretations being applied and "gold-plating").[1641]

·  Traditionally, EU law has been implemented through directives, following principles of "minimum harmonisation". Such an approach of setting minimum standards allows flexibility for national regulators to reflect national features and risks, and to address situations where the EU transposition of Basel is thought to be inadequate. This approach has not unduly constrained the use of judgement.

·  The EU has been moving in the direction of greater "maximum harmonisation" (for instance through the use of CRR in relation to bank capital adequacy). This will constrain the ability of the PRA to use its flexibility to go above set standards. Where sensible judgement needs to be exercised, the means by which it is achieved in a world of maximum harmonisation becomes more indirect and thus less transparent. There is a cost to such approaches in terms of the clarity of policies and supervisory actions.

·  EU processes have also moved in the direction of using more detailed rule-making, both at the level of legislation (Directives and Regulations) and the Technical Standards that are developed and implemented by the European Supervisory Agencies (EBA, EIOPA, ESMA). Rules which apply to 27 countries tend to require more detail to deal with the inevitable exceptions to reflect national circumstances. This also brings a much larger overhead of monitoring and compliance in regulatory bodies and firms.

·  The European Banking Authority has proposed the creation of a single Handbook of supervision. This may be a precursor to attempts to harmonise not just the rules of supervision but also the process of supervising and thus the application of judgement. The ECB is also expected to develop its own Handbook. The extent of overlap risks a substantial lack of clarity in this area and will bear close monitoring.

995. A particular concern is that maximum harmonisation may restrict the national regulator from exercising discretion and from successfully delivering a judgement-based approach. Andrew Bailey pointed out:

    a number of developments either have, or are likely to, pose a risk in future to the exercise of appropriate judgement. The introduction of "maximum harmonisation" (for instance in the Regulation (CRR) part of the overall CRD4 package for bank capital adequacy) will constrain the ability of the PRA to use the flexibility to go above minimum standards.[1642]

Furthermore, the European Banking Authority's proposal to create a single 'Handbook' of supervision is a step in the direction of harmonising not just the rules of supervision, but also the process of supervising banks and thus the application of judgement.[1643]

996. The UK regulator has been considering what measures it can take at a national level to address the deficiencies in Basel III and CRD IV/CRR. Andy Haldane told the Commission that one of the things the UK regulator could do is to require greater transparency regarding the inputs into internal models. Furthermore, he further suggested that where the UK regulator has misgivings about the robustness of models, it could require something simpler and more robust in their place.[1644] The Commission was told that internal models are particularly inappropriate for portfolios of assets which contain large idiosyncratic loans, such as commercial property portfolios. Andrew Bailey described commercial property models as "ropey".[1645] The PRA has therefore introduced a more robust approach for commercial property portfolios, which could be extended to other asset classes. A further measure that the PRA has explored is the imposition of floors in models below which capital would not be allowed to fall irrespective of a model's output.[1646]

997. 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.

998. 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.


999. Regulators are concerned with ensuring that banks maintain appropriate capital resources, both in terms of quantity and quality. There is an expectation that a significant proportion of a bank's capital will be of the highest quality—ordinary shares (equity) and reserves (retained earnings). All capital is expected to be capable of absorbing losses. Banks are expected to refrain from innovation in new capital instruments intended to contribute to regulatory requirements if they are ineffective at absorbing losses. Lower quality capital may, however, play a role when a bank has failed.[1647]

1000. The Commission noted in its First Report the importance attached to resolution in the new regulatory regime and that a bail-in regime is being designed as a resolution tool for large systemically-important banks. Under such a regime, creditors holding bail-in bonds would share in the losses of a bank in an insolvency scenario. We noted, however, that there are doubts about the workability of such a regime and whether it will be agreed at an international level. In particular, the Commission raised a concern as to whether it was realistic to expect that in a crisis the authorities would be willing to exercise their powers to impose losses on creditors.[1648] Since our First Report, a form of bail-in has been used in Cyprus to deal with financial crises. Large depositors in banks were required to accept a reduction in the value of their deposits and so bear a share in the losses of the banks in which they had invested. These measures were met with a strong negative reaction (although this did not result in restitution). Cyprus is one of the few cases where bail-in has been attempted. Its circumstances were unusual, however, and it remains to be seen how bail-in could be applied in the case of a large bank in the UK. As we note in Chapter 4, there remain questions about the extent to which we can be confident about relying on bail-in tools to tackle the too-big-to-fail problem.

1001. The Commission also reported that there may not be sufficient demand for bail-in debt, particularly amongst traditional large holders of bank debt, such as pension funds. However, when this point was raised with Sir Mervyn King, he suggested that bail-in bonds might be investable for certain types of pension fund, notably defined contribution pension funds which are able to invest in higher risk assets. He acknowledged that such investments might not be suitable for defined benefits funds which need to match their assets and liabilities.[1649]

1002. In Chapter 3, it is noted how excessive reliance came to be placed on credit rating agency ratings. Such ratings have also been hardwired into the regulatory system. The most pervasive regulatory use of such ratings has been in determining capital requirements for banks.[1650] Regulators have been trying to reduce reliance on rating agency ratings, but progress has been slow. In response to demands in 2012 by G20 Ministers and Governors for further progress in ending mechanistic reliance on such ratings, the Financial Stability Board reported back in November 2012 with a "roadmap" with milestones for action.[1651] 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.


1003. In Chapter 3, we highlighted that the absence of a regulatory leverage ratio requirement meant that regulators failed to prevent banks pursuing aggressive growth strategies. Instead, regulators relied on a flawed approach that involved using risk weighted assets (RWAs) and internal models to calculate regulatory capital requirements. In oral evidence, Andy Haldane described the inputs to models as "a complete black box".[1652] The lack of transparency resulted in huge inconsistencies in risk asset weightings, as confirmed by the results of a survey by the Basel Committee on Banking Supervision, which handed the same hypothetical trading portfolio to 15 large banks in nine countries and asked them to calculate the total capital required to support it. The results ranged from €13m to €35m, and in several cases the variation within individual asset classes—such as credit risk or interest rate portfolios—was more than eight times.[1653]

1004. Since its First Report, the Commission has taken further evidence that the problems associated with RWAs will not be solved, which reinforces the need for a robust leverage ratio. Sir Mervyn King was sceptical of risk weights, which are set by international agreement and difficult to change, noting:

    It is somewhat absurd, for example, that a zero risk weight is applied to sovereign debt when there are certain types of sovereign debt that no one in their right mind would think was appropriate to have a zero risk weight. The same applied to mortgages. Indeed, to my mind the most stunning example of that was Northern Rock which, in the summer of 2007, not only said that it wanted to return capital to its shareholders because it had too much, but it was the most highly capitalised bank in the United Kingdom according to the official risk weights. Yet, within literally weeks, it ran out of money. That tells you quite a lot about how inadequate the normal risk weighted measures of capital can be.[1654]

1005. As noted above, the absence of a leverage ratio is being addressed through Basel III and was also considered by the Independent Commission on Banking (ICB). As the Commission noted in its First Report, the Government chose to reject the ICB's recommendation that the leverage ratio should be increased from the 3 per cent imposed by Basel III to 4.06 per cent, which would been consistent with the proposed increase in Tier 1 capital requirements for large ring-fenced banks from 8.5 per cent to 11.5 per cent of RWAs.[1655]

1006. Banks and building societies who hold a large proportion of their assets in the form of loans that attract a low risk weighting under the RWAs approach (notably mortgages) have raised particular concerns. This is because the imposition of a leverage ratio may require them to hold more capital against the same portfolio of assets. The Chancellor lent his support to these arguments, telling us:

    There are some banks that, frankly, we would regard as engaging in less risky activity than other banks but that would be more affected by a leverage ratio, which seems a bit perverse.[1656]

He also described "compelling" representations made to HMT Treasury by banks in respect of the leverage ratio.[1657]

1007. Building societies have argued that, as they face constraints in raising capital because of their mutual status, they may have to restrict lending.[1658] It should however be noted that building societies were not immune from the impact of the financial crisis, with a number either failing (Dunfermline)[1659] or being acquired by other building societies (such as Chelsea[1660] and Norwich & Peterborough)[1661]. Sir Mervyn King agreed that issues in the building society sector were not a sufficient argument against a higher leverage ratio:

    Lord Turnbull: [..] Are we allowing the Nationwide tail to wag the dog—that the leverage ratio that would be suitable for the industry generally is not being put in place, because we haven't found a particular solution for one segment of this market?

    Sir Mervyn King: It is the tail wagging the dog. There is a separate issue about mutuals and building societies in general, which has never been resolved. It is how you ensure that there is an adequate loss-absorbing capacity before the depositors are called upon to bear losses, given that in a mutual organisation they are, in effect, the shareholders. This problem has not been properly resolved. We raised it way back in 2007-08, and it has been a problem that has been overhanging us since, without any resolution. There is a need to deal with that problem, but it is quite separate from the question of the appropriate levels of leverage for banks. [1662]

1008. We received highly persuasive evidence that the 3 per cent leverage ratio requirement imposed by Basel III is too low. The ICB's 4.06 per cent ratio may have suggested spurious precision, but the principle that the leverage ratio needs to be raised as well as RWAs is sound. This view is supported by Sir Mervyn King, who told us:

    in the crisis, it was not risk-weighted capital ratios, but leverage ratios that proved a better predictor of which banks would get into difficulty. It is why I personally would attach more weight to a leverage ratio as a means of stopping some major problem. Supervisors would normally say that they want to use leverage ratios as a backstop. I understand that. It is a sensible thing to do, but I would rather have a tighter backstop than 33:1.[1663]

Sir Meryvn King said that he would be "much happier" with leverage ratios of 10 to 20.[1664] Andy Haldane pointed out that during the crisis 4 per cent would not have been sufficient to prevent some of the banks failing and that longer term there is a programme of work to be done to explore whether even 4 per cent is sufficiently prudent:

    Personally I would be setting that leverage ratio at a somewhat higher level than that currently prescribed by Basel III. As you know, it is set at 3 per cent, or 33 times leverage. During the crisis, we found that those levels of leverage were often a recipe for failure and, in the longer term, there is a strong case for thinking about a leverage ratio north of that 3 per cent, and one that is not reliant on risk weight. [1665]

1009. The leverage ratio imposed by Basel III is considered to be a regulatory backstop, with RWAs still perceived as the key regulatory tool for mitigating risk on banks' balance sheets. There is a question, however, of whether the leverage ratio should be a frontstop in some cases given that for the most complex banks this simpler measure appears to have had greater pre-crisis predictive power than measures based on complex risk weightings.[1666] Andy Haldane has pointed out that the introduction of a leverage ratio under Basel III is good news from a robustness perspective but "less good is the fact that there will be a clear hierarchy of solvency rules with the frontstop provided by a risk weighted capital ratio and with the leverage ratio serving as backstop. In the hierarchy, leverage will be second in line."[1667] There is a case for the hierarchy to be reversed, "with the leverage ratio playing the frontstop role given its simplicity and superior predictive performance".[1668] Michael Cohrs was also a strong supporter of the leverage ratio, telling us: "leverage ratio-total assets divided by equity, that is how I would regulate the banking system. It is the only indicator. [...] So that is how I would come at financial regulation; I would rely heavily on simple leverage ratios".[1669] The Chancellor was not supportive of the leverage ratio being a front stop:

    having thought about it and having looked at the impact on a number of building societies and banks, our feeling was that it would become the front-stop rather than the back-stop, and, as I said, I am a big supporter of the leverage ratio but it should act as a back-stop.[1670]

1010. The Chancellor was also not supportive of our recommendation to give the FPC the role of determining the leverage sooner than initially proposed by the Government. He told us:

    We have a reasonable compromise, which is that we are trying to get—indeed, we are succeeding in getting—a 3 per cent leverage ratio implemented at a European level. Our commitment to the Financial Policy Committee has been to give them a leverage tool by 2018—subject to a review in 2017, so there is a caveat—but, in other words, not to proceed so far ahead of the European pack that we are not even getting the European rules agreed before we are implementing our own rules.[1671]

1011. 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. As we noted in our Second Report, Dr Carney has said that it is "essential to have a leverage ratio as a backstop to a risk-based capital regime."[1672] 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.

1012. 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.

1013. 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.

Aligning tax rules with regulatory objectives


1014. As we explained in the previous section, in ensuring the safety and soundness of banks, regulators are concerned with limiting excessive leverage in banks' balance sheets and in ensuring that banks hold high quality, loss absorbent, capital. Existing tax rules are, however, misaligned with these objectives. Banks fund their assets with a mixture of debt (by borrowing from creditors through issuing debt instruments and accepting deposits) and by issuing shares to shareholders (equity). Under the current UK corporate tax system, banks can deduct from their taxable profits interest payments to creditors but not dividends paid to shareholders.[1673] This creates a tax incentive (or 'tax bias') for banks to issue debt rather than equity and so is misaligned with regulatory objectives. Andy Haldane has argued that current complexity in regulation arises partly to compensate for this situation:

    One of the reasons why we have not just capital regulation but very complex capital regulation is that we are trying to induce banks to do something that the tax system at present provides a disincentive to do, which is to raise extra equity. So my hope would be that if the differential treatment were to be removed, banks themselves would have fewer disincentives and perhaps even some incentives to hold sufficient equity and that would lessen the burden on this complex regulation.[1674]

1015. The relationship between tax and leverage is, however, complex and the extent to which tax rules encourage leverage in banks is debatable. While modelling by economists and academics finds that the tax bias does influence levels of debt in banks, tax practitioners and banks argue that regulatory requirements relating to capital, liquidity and leverage are more compelling reasons behind banks' choice of financing. [1675] The BBA has pointed out that debt versus equity options are also limited by capital markets; reasons why investors might prefer debt over equity include risk appetites and reliability of income streams.[1676]

1016. Not only does the tax system incentivise banks to increase leverage, it also disincentivises banks from holding capital in its highest quality form (equity) and encourages banks to hold capital in hybrid instruments. Hybrid instruments are neither pure equity nor pure debt, but typically lie somewhere between the two, with characteristics of each. Such instruments are favoured by banks because they represent a lower cost of capital after tax: they are permitted by Basel regulations to qualify for Tier 1 and Tier 2 capital status, while retaining favourable debt characteristics such as interest deductibility. It is notable that the UK hybrids market grew to around $100 billion between 2000 and 2007, representing around 25 per cent of UK banks' tier 1 capital.[1677] A former senior adviser to the OECD pointed out:

    There is anecdotal evidence of the tax bias to debt encouraging higher levels of gearing by companies, and banks have tended not only to gear up to the levels of debt allowed under regulatory capital rules but also to issue hybrid, equity-like, forms of debt, rather than ordinary share capital, where that satisfied both the regulators and the conditions for a tax deduction.[1678]

While hybrid instruments can have a place in a bank's overall capital, they are less loss-absorbent than pure equity. Commentators including the IMF and OECD are cautious about encouraging their use, noting that "[...] innovation in financial instruments has increasingly blurred the distinction between debt and equity and might have opened new options for tax avoidance" and concluding that "there may be a case for tax systems not to encourage Tier 1 capital to be issued in the form of debt-like instruments (which in regulatory terms are functioning as equity.)" [1679]

1017. Banks' use of hybrids in this way illustrates the way in which the tax system can pull against, rather than alongside, regulatory objectives. Neutralising the tax differences between debt and equity would not only create incentives for banks to hold capital with more loss-absorbent properties, it would reduce arbitrage opportunities. Professor Devereux, Director of the Oxford University Centre for Business Taxation, told us that:

    We cannot see any good reason why debt and equity should be treated differently by the tax system as a matter of principle. Indeed, the fact that they are treated differently by the tax system creates a number of distortions—both to the behaviour of banks and for other companies—and a number of problems with the administration of the system in trying to define what debt and equity are.[1680]

Similarly, Ernst & Young thought it important for the tax system to support regulatory objectives, and observed that the current tax rules do not do so on a consistent basis:

    It would be helpful if the tax system were aligned to incentivise similar behaviour to regulation, so that complying with regulations does not penalize banks from a tax perspective.[1681]

The Government also noted that "taxes and regulation face complex complementarities and potential trade-offs, which are still poorly understood."[1682] Bank behaviour is more constrained by regulation and corporate governance measures than by tax.[1683] ACCA has argued: "the tax system sets boundaries for what can legally be done, but it is not in itself a suitable tool for promoting that which ought to be done."[1684]

1018. 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. Options are explored below.


1019. Removing the tax bias would provide a level playing field between debt and equity, otherwise known as tax neutrality. Introducing tax neutrality for the banking sector would provide banks with more of an incentive to hold more capital in relation to debt than is currently the case and has been advocated by Sir Mervyn King amongst others, who said that he was "in favour of a neutral tax treatment of different types of investment income and income from capital."[1685]

1020. Amongst the range of reforms possible, there are two main options which would achieve tax neutrality. One option would be to remove the deductibility of interest payments, thus placing debt on a level footing with equity. This is called the 'Comprehensive Business Income Tax' (CBIT). Under CBIT, banks are disallowed a deduction for interest expenses, but are not taxed on interest income received on outstanding loans to other firms.[1686] There are no current, international examples of CBIT in practice as there are a number of practical obstacles including the difficulty of unilaterally introducing a new tax system which would result in higher tax bills for companies with debt, competition disadvantages in attracting investment by multinational enterprises and the potential for double taxation. Nonetheless, the United States Congress is considering whether CBIT could be used to offset a reduction in the headline rate of corporation tax. [1687]

1021. The other option, which most observers believe to be more practical, is called the 'Allowance for Corporate Equity' (ACE) and has been adopted by a small number of countries who did not limit this reform to the banking sector.[1688] Under the ACE, companies would deduct from their taxable profits their interest payments plus an amount equivalent to what they would have to pay their shareholders in interest if all the company's equity were debt (the notional return on equity).[1689] The Mirrlees Review called for an introduction of an ACE system as part of wide-ranging reforms to the entire tax system. [1690] This would incentivise borrowers to issue new equity in exchange for debt, contributing both to financial stability and to the outlook for economic recovery.[1691] However, introduction of an ACE could justifiably be limited to banks on the basis that over-leverage in banks is particularly harmful and can have a more dramatic effect than in the rest of the economy by leading to financial instability. Providing an incentive for banks to hold more equity in relation to debt by means of an ACE is therefore a legitimate tool to influence bank behaviour in this regard.

1022. The Treasury and HMRC told us that introducing any reform would involve practical problems: "measures designed to directly address the debt-equity bias in the tax system would be disruptive, and would have unpredictable—but potentially significant—behavioural and location effects."[1692] They also argued that given that corporation tax rates in the UK are following a downward trajectory: "these reductions will significantly reduce the distortion, and therefore by implication reduce any benefit that can be achieved from reform."[1693] In addition, research by the IMF has suggested that for the very largest banks, "large reforms would be needed to have a marked effect." [1694]

1023. For the reasons outlined above, introducing a CBIT unilaterally would not be an attractive option. By contrast, the ACE could have benefits beyond achieving tax neutrality. As Professor Devereux explained:

    Very broadly, taking international things into account, giving an extra relief for equity and leaving the tax rate as it is makes the UK more attractive. Disallowing interest will make the UK less attractive for banks locating and doing their business here. There are intermediate positions, and one may change the tax rate as well, but I think that the key issue in terms of which direction to go is whether we are making the UK more or less attractive to international banks to locate their business here. [1695]

1024. Rebalancing the tax system by introducing an ACE without any offset elsewhere would inevitably have cost implications and would reduce companies' tax bills. According to IMF estimates, applying an ACE to the whole economy would reduce government revenue by 0.5 per cent of GDP.[1696] If limited to the banking sector, the Treasury have estimated that the average annual cost to the Exchequer would be in the region of £1 billion. If the scope of the ACE was narrowed still further to include only 'new equity' (only applying to the amount of overall increase in equity from the date of reform) the cost would be closer to £100 million per annum.[1697]

1025. The cost of introducing an ACE for the banking sector could be mitigated by increasing the rate of the Bank Levy, an annual charge which is levied on certain equity and liabilities of banks and building societies.[1698] There is an argument to say that introducing an ACE alongside the Bank Levy would in fact address both tax and non-tax incentives for banks to leverage highly:

    There are non-tax incentives for banks to favour debt over equity. If the tax distortion in favour of debt is removed through an ACE, an argument can still be made for the Bank Levy to counter these non-tax incentives in favour of debt.[1699]

1026. 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.

Accounting for regulatory needs


1027. We noted in Chapter 3 that auditors failed to provide a last line of defence against banks' questionable reporting on their own businesses, and that accounting rules encourage pro-cyclicality in the banking system because the nature of accounts is to look backwards.[1700]

1028. Accounting standards are governed by EU legislation, which incorporates international rules. Compliance with International Financial Reporting Standards (IFRS) has been mandatory for UK listed companies, including banks, since 2005.[1701] We received a great deal of evidence regarding general deficiencies in IFRS. Beyond considering issues particularly relevant to banks, such as valuation of assets, the evidence questioned whether a focus on convergence with US accounting standards and a desire for consistent application of IFRS led to an over-emphasis on compliance and box-ticking, at the expense of professional judgement and willingness to correct emerging issues. Concerns were also raised more generally about whether IFRS allows accounts to be sufficiently prudent to provide a true and fair view of a company's financial position, which is a legal requirement under the Companies Act.[1702] Prudence is further considered later in this chapter. There is clearly widespread concern about IFRS and the method by which it is introduced into EU law. As this is beyond the scope of this Report, this may be an issue which the House of Lords Economic Affairs Committee or the Treasury Committee wish to consider in due course.

1029. Given that governance of accounting standards is largely carried out at an international level and that there are very limited opportunities for UK accounting standard-setters to make unilateral changes to accounting standards, we have focused on practical ways for banks to provide better accounting information to regulators and investors. Banks' implementation of accounting rules relating to valuation of assets including prudence, modelling of impairment reserves and the use of fair value have implications for financial stability and investor confidence.[1703] Problems with these rules have not yet been resolved despite ongoing debate within the accounting profession since the onset of the financial crisis, partly due to the complex process by which IFRS is adopted into EU law.

1030. 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.


1031. Accounting priorities for the banking sector focus on the appropriate valuation of assets and liabilities and the impact of this on prudential capital requirements. We have considered what practical measures can be introduced to provide better accounting information on valuations.

1032. IFRS can result in pro-cyclical valuations of bank assets and liabilities. In apparently positive economic conditions this causes bank assets to be overstated (and liabilities to be understated) and allows banks to appear to be meeting regulatory capital requirements while their capital buffers may in fact be grossly inadequate.[1704] In particular, bank models used to recognise a decrease in the value of a loan asset within the accounts under IFRS are based on 'incurred-losses' and do not take account of expected losses. Most written evidence agreed that loss provisioning by banks would have been more conservative if an expected-loss model, which provides for impairment once anticipated, had been in place.[1705] The International Accounting Standards Board (IASB) acknowledged that this criticism was "partially justified" and has been developing such a model in response.[1706] This will require banks to take some provisioning for all assets, even if they are not impaired.[1707] However, even if the expected loss model had been in place from 2005, this would not have prevented under-provisioning entirely—the problem was that the scale of losses was entirely unexpected. As the IASB pointed out:

    The clue is in the name of this as an expected loss model. Expectations will be different among different people and they will probably be wrong. We need methods which underpin consistent expected loss provisions or else we will just be back where we started.[1708]

1033. 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.


1034. Users of bank financial statements come from a broad range of backgrounds, including investors, regulators and tax authorities, and their needs can be quite different. For example, Richard Murphy of Tax Research LLP commented that "accounting for tax [...] is profoundly misleading", due to the dislocation between the tax charge in the accounts and cash tax paid. [1709] Regulators have consistently spoken out about their dissatisfaction with IFRS,[1710] with Andrew Bailey telling the Treasury Committee that "we disagree with the accounting standards, frankly, in terms of their lack of forward-looking loss provisioning".[1711] The Financial Reporting Council (FRC) and other stakeholders also raised concerns that the principle of prudence, described in the 2001 Framework for the Preparation of Financial Statements as "the inclusion of a degree of caution in the exercise of judgements needed in making the estimates required under conditions of uncertainty such that assets or income are not overstated and liabilities or expenses are not understated", is no longer part of the IASB's Conceptual Framework (introduced in 2010).[1712]

1035. The accounting profession has recognised that the concept of neutrality ("trying to get the right answer without bias") as introduced by the IASB's Conceptual Framework does not align with the more prudent approach to capital taken by regulators. [1713] However, they argue that neutrality is preferable to excessive conservatism, sometimes interpreted as 'prudence'.[1714] Professor Prem Sikka of the Centre for Global Accountability at the University of Essex, suggested that the particular needs of regulators, such as a more prudent valuation framework, may not be reconcilable with current accounting philosophy:

    It may well be that the regulators may have to specify different things[...]Otherwise the danger is that we would expect one set of accounts to provide a whole lot of different things that cannot actually be done.[1715]

This suggestion raises the question of whether there should be a separate accounting regime for banks. The benefit of such an approach would be to present a more prudent view to shareholders and others of the financial position of the bank. There are, however, a number of legitimate concerns with such a proposal, including definition of boundaries, encouraging arbitrage and the risk of a growing shadow banking sector.[1716] Indeed, the Pozen Report to the United States Securities and Exchange Commission recommended that industry-specific accounting standards be eliminated.[1717]

1036. Another option would be for separate accounts to be provided to the regulator, in addition to standard IFRS accounts. This was advocated by Antonio Horta-Osario, who pointed to the system in Brazil, Portugal and Spain, where regulators set particular accounting standards for banks which are then reconciled to IFRS accounting standards in the financial statements:

    For example, in Brazil, Portugal or Spain the central bank—the regulator—decides the accounting standards [...] What I do think is that when you are speaking about banks, you should not want a mark-to-market view to be taken for the definition of capital, because I think that for a capital definition you would take a prudent view and not a mark-to-market view. By definition, a mark-to-market view is a central view, and a prudent view is not a mark-to-market view. In my opinion, the way to solve this problem is not to change IFRS but to consider whether banks should not calculate their capital according to a different set of rules, as you do, for example, for the purposes of tax calculation. When you calculate tax, you do not use IFRS; you use the HMRC tax system. Why would you not consider having different accounting standards rules for the purposes of capital calculation—one that is prudent, not mark-to-market? Then you could, in the accounts of the banks, ask the banks to publish the reconciliation between capital definition in prudent accounting standards defined by the regulator, and IFRS accounting standards, which are the ones used by the investors. This is already done in several countries in the world, such as Brazil and Spain. [1718]

This could be an opportunity for action to be taken on a UK level to achieve the practical outcomes which would otherwise be delayed by waiting for international agreement on IFRS. We note, however, that Dr Carney does not currently favour a separate set of accounts. He told the Treasury Committee:

    although what I would say is that, and I suppose I could be convinced otherwise over time but I do start from a position where I prefer to not have two sets of accounts, a regulatory set of accounts and a public set of accounts.[1719]

1037. The regulators have compensated for deficiencies in accounting standards by applying their own more conservative standards.[1720] As Andy Haldane explained:

    Even if accounting standards are not quite in the right place, we, as regulators, can impose our own regulatory filters, recognising more provisions early on. Indeed, the [...] FPC[...] asked that banks look through and provision more on a forward-looking basis than current accounting standards permitted.[1721]  

The slow pace of change in IFRS means that there may be other areas where regulators require a deeper understanding than IFRS accounts provide and where enhanced reporting to regulators would be of benefit. These include the true extent of expected credit and other losses and how they are derived; the quality of a bank's earnings and the extent and nature of accounting uncertainty (including the use of prudent valuations). One of the ways in which UK regulators have already sought to address deficiencies in IFRS is by requiring banks to complete a prudent valuation return for regulatory purposes. This requirement recognises that the approach taken by banks to fair valuing assets can vary substantially and that the fair values in firms' annual reports do not provide substantial information on the degree of uncertainty in the valuations of financial instruments, such as derivatives.[1722] There are also numerous regulatory returns that must be completed by banks and the introduction of Common Reporting (COREP)[1723] with CRD IV will require further specialised reporting to regulators.

1038. Sir David Tweedie, in a recent letter to The Financial Times, discussed some of these issues.[1724] In that letter Sir David said he was not "persuaded by arguments in favour of a separate accounting regime for banks" and added:

    Many large corporates have a greater exposure to financial instruments than a mid-tier bank. Introducing a separate accounting regime for only certain types of entities acting as financial institutions risks exacerbating the problem of a shadow banking system.

Sir David also differentiated between the concept of accounting profit vis-a-vis regulatory profit:

    no accounting standard can or should seek to define what element of profits can be distributed. That is quite rightly the job of regulators, while transparency is the concern of standard-setters. While I was chairman of the IASB, I recommended to regulators the notion of "regulatory income" (based on accounting profit with both income based on estimated prices and a certain percentage of profit deducted) on which distributions and compensation could then be based.[1725]

Sir David expanded on this point in evidence:

    in the accounts you show the accounting profit, and then you say, 'Now, regulators want a certain amount held back as an undistributable reserve.' That gets deducted from profit in what we called regulatory income. You could also deduct from that all income from modelled fair values, and then you end up with a level that is suitable for distributions, compensation calculations and so on. That is different from the accounting profit, because once you start bringing in phoney provisions, you have a problem, whereas what we are saying is, 'You can get exactly what you want,' which is retaining profit by having undistributable reserves, and that does not distort—it is clear—and that can be settled by the regulators.[1726]

1039. 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.

Clearer auditors' reports

1040. The purpose of an auditor's report is to assure the shareholders that the financial statements represent a true and fair view of the business.[1727] This is particularly important for banks, given the uncertainties involved in valuing their balance sheets and the potentially catastrophic consequences if banks fail. However, while a great deal of work is carried out during an audit, the typical audit report consists of 'boilerplate' statements which add little to shareholders' understanding. The Institute of Chartered Accountants for England & Wales (ICAEW) commented:

    The responsibilities of auditors for reporting on the front section of the financial statements are currently limited. Auditors read this information and must report if the information provided is inconsistent with the financial statements or contains material the auditors know to be untrue. Annual reports have expanded over the years and banks and other reporting entities provide significantly more information in the front section of annual reports. The scope of the audit report, by contrast, has remained relatively static, being largely focused on the financial statements. It may be time to reassess this.[1728]

1041. A public debate about the format and scope of the audit report is already under way, and the International Auditing and Assurance Standards Board (IAASB) recently considered a number of ways in which it might be improved.[1729] Andy Haldane suggested that an alternative to the existing format should be:

    [a] more graduated approach to scoring and to evaluating solvency than the binary qualifier [...] so that there is a way for the auditor to convey a going concern without pressing a button that flashes a big red light [...] in principle it would be better to provide a spectrum of views on the health of the balance sheet, rather than this black-or-white binary distinction.[1730]

Professor Mike Power of the London School of Economics has observed that "many internal auditors grade their findings, and privately external auditors do this. So the knowledge and capability exists."[1731] However, there are concerns that a grading system would not achieve the objective sought and could lead to problems currently associated with qualified opinions. For banks, the risks are particularly severe, the Sharman Report noting that "in practice any signalling of material uncertainties about their going concern may trigger a liquidity shock and potentially a run on the bank."[1732] However, it is dangerous to stifle what may be well-founded concerns about bank solvency for fear of causing a panic.

1042. An alternative to a grading system would be an enhanced audit report, or auditor commentary. Such a commentary could enable auditors to provide a more nuanced view of the business and present more qualitative information to shareholders. This proposal has received support, particularly for the purposes of signposting important matters in the accounts.[1733] While there seems to be an international consensus that auditors need to provide better information, there is no agreement on the best way for them to do so, with different countries having pursued different approaches.[1734] We note that the FRC is currently consulting on the content of the auditor's report and support the FRC's efforts to encourage better communication between the Audit Committee and external auditor, recognising the importance of strong corporate governance by the Audit Committee.[1735] 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.

It's good to talk

1043. Earlier in this chapter we concluded that there should be better alignment between the tax system and regulatory objectives. There appears to be more that could be done to improve communication between bank regulators, the tax authorities and auditors in order to reduce the opportunity for banks to game differences in rules and regulations. Banks are currently able to take advantage from the lack of dialogue. As the ICAEW noted: "businesses in general, and banks in particular, are always likely to seek opportunities for arbitrage where there are differences in prices or in regulation [...] we believe that [...] it would be better to focus on the regulatory, tax and financial reporting systems [...] HMRC, the FSA and FRC could also more closely co-ordinate their approach to the largest banks."[1736]

1044. Currently, there is an information gateway between HMRC and the regulator but the range of information which they are allowed to share is narrow.[1737] The Government told the Commission that:

    This inevitably limits the regulator's ability to discuss institution specific issues with HMRC, including circumstances where this would have benefits [...] In a number of enquiries, banks have claimed that their reason for undertaking a transaction in a particular way or their purpose for being party to [a] transaction was for regulatory purposes, but information restrictions mean HMRC has been constrained in its ability to confirm this.[1738]

1045. The FSA recognised its lack of tax expertise and conceded that tax issues had not been "a significant point of focus" for them in their prudential supervision of banks.[1739] However, given that the FSA also acknowledged that "much of the complexity in financial structures and at least some of the leverage arises from banks' efforts to optimise orthogonal tax and regulatory structures simultaneously", it seems that both bank regulators and supervisors should be paying far more attention to tax issues.[1740]

1046. There are other areas where regulators have an interest in tax, such as the treatment of deferred tax assets for regulatory capital purposes. As the OECD has pointed out:

    Banks have a key non-tax interest in ensuring that they receive full tax relief for commercial losses, as tax losses can in some circumstances count towards regulatory capital available to support their business. There is some evidence of tax planning by banks primarily aimed at maximising recognition of tax losses for regulatory capital, rather than tax/cash-flow, purposes.[1741]

KPMG told us that this was one particular area where closer dialogue between the PRA and HMRC would be useful, commenting that "regular dialogue between HMRC and UK regulators would be sensible and desirable; our impression is that such dialogue is limited at present."[1742] The Treasury observed that:

    Having easily accessible gateways for information and knowledge sharing would help both bodies to identify any tax and regulatory arbitrage, and take necessary action needed to address this [...] there would also be benefits in terms of ensuring tax rules dovetail appropriately with regulatory requirements [...] to ensure that the consequences of the existing tax rules do not drive behaviours in ways that undermine regulatory objectives."[1743]

1047. 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.

1048. The House of Lords Economic Affairs Committee described the lack of dialogue between auditors and bank supervisors in the run up to the financial crisis as a "dereliction of duty". The Committee continued:

    Adequate and timely dialogue between bank auditors and supervisors is of the first importance. It is essential not only to enable the auditors to audit more effectively and the supervisors to supervise more effectively, but in particular to overcome the problem caused by the understandable reluctance of auditors to qualify banks' accounts.[1744]

Witnesses agreed that such dialogue needed to be robust. Paul Sharma, Director of Policy, FSA, said that:

    I am quite clear, and the whole senior management designate of the PRA is quite clear, that we cannot be an effective prudential regulator without significant, good, strong, ongoing, timely two-way communication between the auditors and the supervisors. That is why we have acted to put guidance in place.[1745]

This guidance consists of a Code of Practice which sets out the nature of the relationship between supervisor and auditors, the form and frequency of communications and responsibilities and scope for sharing information. [1746]

1049. Measures are in place to secure the quality of dialogue between regulators and auditors, including a requirement for bilateral meetings.[1747] The Government amended the Financial Services Bill to require the PRA to have arrangements for sharing information and opinions with auditors, and to require the Code to be published and laid before Parliament. While this is clearly an improvement, there are concerns that over the passage of time, the practical use of the Code will fall into abeyance.

1050. Some witnesses told us dialogue between regulators and auditors should be made mandatory, as recommended by the House of Lords Economic Affairs Committee. Hans Hoogervorst, Chairman of the IASB agreed that this was "common sense."[1748] Stephen Haddrill, Chief Executive of the FRC, described it as having "no downside" and Paul Sharma agreed "wholeheartedly" that this should be the case. [1749]

1051. The existing Code recommends that bilateral meetings between supervisors and auditors take place at least on an annual basis, with further bilaterals as necessary when planning audits.[1750] David Barnes, Managing Partner of Public Policy at Deloitte, told us that there were precedents for going further than this, and requiring meetings in statute:

    in the Banking Act 1987, you had a requirement for auditors to do set pieces of work under the section 39 regime. That forced a number of touch points between the auditors and the regulator: it was not written in stone, but it did almost require the auditors to meet with the regulators, either on a bilateral or a trilateral basis, frequently during the year. When that was abolished, I think in early 2000, there were fewer touch points there, and that, I think, was one of the reasons why the meetings became less regular. They still happened, but they became less regular than they had hitherto been.[1751]

1052. The wider relationship between the supervisor and auditors is clearly key to improving the quality of dialogue. As Tony Clifford, partner at Ernst & Young, told us:

    it is not going to be the formal linkages and duties that will make a huge difference. For the dialogue between auditors and regulators to work well, it has to be on an informal basis—and quite often to make sure that the regulator can operate in a way which is timely and can shut the door before the horse has bolted. [...] It might well be just a phone call to say, "We just noticed that one of the screws on one of the hinges is loose."[1752]

Establishing effective dialogue requires a culture of mutual trust, which has been missing in the past. Each side has attributed this fault to the other, with the accounting profession complaining that the information flow is one-way. On the one hand, as the ICAEW pointed out: "while some bilateral meetings provide a frank exchange of views, auditors report other meetings with the FSA where the information flow is one way, with the supervisor listening to insights from the auditor but providing little in exchange."[1753] On the other hand, the FSA considered that external auditors did not always share some useful information.[1754] According to a joint discussion paper issued by the FSA and FRC, this lack of dialogue has led to the situation where:

    There have also been occasions where the FSA and a firm's auditors have been separately encouraging the firm to reconsider an accounting estimate it was proposing to use; had the parties been aware that they shared each other's concerns, they both might have raised those concerns more forcefully with the firm. This is a good example of how more can be achieved working together rather than working separately. Both parties need to learn that, where there is a concern, the default should be to share the information unless there are restrictions that would prohibit this.[1755]

The FSA acknowledged that there is a need "to create the right culture among our supervisors and among the auditors such that there is the degree of trust and the degree of urgency so that we get the kind of good quality sharing of information that is absolutely necessary for a modern, effective, prudential regime."[1756]

1053. 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.

The new regulatory structure and our approach

1054. Rules are no substitute for good judgement. Improved banking standards require regulators who are willing and able to take action as necessary on the basis of judgement rather than simply following rules or mindlessly collecting data. This requires them to be bolstered by accountability mechanisms that empower them to take difficult decisions when they are needed and give them the opportunity to explain their actions in public. This section considers the structure and powers of the new regulators and how their accountability might be improved.

1055. Regulatory failure played a major role in permitting standards to slip in the banks. This in turn added to the severity of the crisis. The Government has responded with fundamental structural reform of financial regulation. The Financial Services Act 2012 concentrated macro- and micro-prudential regulatory responsibility at the Bank of England, with the creation of:

·   the Financial Policy Committee—a subcommittee of the Court of the Bank—which is responsible for identifying and monitoring, and taking action to remove or reduce, systemic risks; and

·  the Prudential Regulation Authority (PRA)—a subsidiary of the Bank of England— which prudentially regulates banks, insurers and major investment firms.

Conduct regulation now lies with the Financial Conduct Authority (FCA), separate from the Bank.

1056. The new regulatory structure aims to address conflicts that arose from a single regulatory body being responsible for both prudential and conduct regulation. Michael Foot, a former Managing Director at the FSA, described some of the problems of the former regime:

    We had conduct of business and prudential people in the same building arguing like cat and dog because they had never been together before and whether it was mortgage endowments or whatever the issue was, there was a prudential aspect and a conduct of business aspect.[1757]

1057. Under the tripartite arrangements put in place upon the creation of the FSA in the late 1990s, involving the FSA, the Bank of England and the Treasury, the different parties adopted a 'silo' approach focusing on their areas of responsibility and failing to engage with one another sufficiently. Lord Turner, Chairman of the FSA until March 2013, noted that:

    The two institutions (Bank and FSA) were so keen to concentrate on their own specific responsibility—the Bank on monetary policy defined around the inflation rate objective, the FSA on the supervision of institutions on an individual case-by-case basis that, (as Paul Tucker […] has expressed it)—we left an under lap between us.[1758]

Although any division of responsibilities may lead to the creation of silos, the new structure should bring benefits from returning prudential supervision to the central bank. As Sir Mervyn King pointed out, "one of the reasons for putting the PRA inside a central bank is to integrate the work of the two institutions more closely", which should result not only in more effective supervision, but in longer term cost savings.[1759] It will be a matter of time to see how well the new structure works. So far there are some encouraging signs. Andrew Bailey, Chief Executive Officer of the PRA and Deputy Governor in the Bank of England for Prudential Regulation, told the Treasury Committee:

    Since the introduction of so-called Internal Twin Peaks in the FSA nearly a year ago, I have observed the benefits of the separation leading to a clearer articulation of both prudential and conduct cases in areas where the two naturally come together and can (again, naturally) lead to different preferences for outcomes.[1760]

1058. However, the new regulatory system gives rise to difficulties of coordination and communication. The former tripartite regulatory structure was found to be inadequate during the Northern Rock crisis, as a result of 'regulatory underlap': the bodies involved, the Treasury, the FSA or the Bank of England, did not, even between them, have all the powers that they wanted in order to solve the crisis. While the new structure may have solved this 'underlap' problem, it has done so at the risk of overlap, and this is reflected in the overlapping memberships of the policy bodies under the new structure and the governing bodies of the authorities:

·  The Governor of the Bank of England sits on the Court of the Bank of England; chairs the Monetary Policy Committee of the Bank of England; chairs the Financial Policy Committee of the Bank of England; and chairs the Prudential Regulation Authority.

·  The Deputy Governor for Monetary Policy sits on the Court of the Bank of England, the MPC and the FPC

·  The Deputy Governor for Financial Stability sits on the Court of the Bank of England, the MPC, the FPC and the governing body of the PRA.

·  The Deputy Governor for Prudential Regulation is chief executive of the PRA. He sits also on the Court of the Bank of England, the FPC and the governing body of the FCA. In addition, the PRA may restrain the FCA from exercising its regulatory powers over PRA-authorised persons if it believes that is necessary to prevent a threat to the stability of the UK financial system or the failure of a PRA-authorised person in a way that would adversely affect the UK financial system (the 'PRA veto').

·  The Chief Executive of the FCA sits also on the Financial Policy Committee and the governing body of the PRA.

This has led some former MPC members to argue for simplification. For example, Kate Barker has said that the responsibilities of the FPC should have remained with the Chancellor[1761], and Dr Sushil Wadhwani has said that the FPC's and MPC's responsibilities would be better performed by one committee.[1762]

1059. In the United States, monetary policy is the responsibility of the Federal Open Market Committee, chaired by the Chairman of the Board of Governors of the Federal Reserve System and comprising other members of the Board and other Reserve Bank presidents. There are no external members. Financial stability policy is the responsibility of the recently-created Financial Stability Oversight Council. This is chaired by the Secretary of the Treasury and comprises regulators and nonvoting advisory members. Again, there are no external members. The Chairman of the Board of Governors of the Federal Reserve is the only person who is a member of both bodies.[1763]

1060. Reliance on the coordinating ability of key individuals, and their ability to cooperate and work as a team, carries risks, particularly in a crisis. When the credibility of the financial system is on the line a robust system is needed: effective management of a crisis should not depend entirely on the personalities in post.

1061. Six statutory Memoranda of Understanding (MOUs) set out the arrangements for these bodies coordination of their work. The MOUs illustrate the complexity of the new arrangements. The statutory MOUs are:

·  between the Bank, including the PRA, and the Treasury re: Financial Crisis Management;

·  between the Bank, including the PRA, the Treasury and the Financial Conduct Authority (FCA) re: International Organisations;

·  between the Bank, including the PRA, and the FCA re: supervision of Markets and Markets Infrastructure;

·  between the FCA and the PRA re: co-ordination;

·  between the FCA and the PRA re: supervision of with-profits policies; and

·  between the Financial Services Compensation Scheme Ltd (FSCS) and the PRA re: Financial Services Compensation Scheme (FSCS).[1764]

In addition, a number of non-statutory MOUs are in place.

1062. Both the crisis management MOU and that between the PRA and FCA on co-ordination will be particularly important. The crisis management MOU is clear in setting out the ultimate responsibility of the Chancellor in a crisis, in line with the Treasury Committee's recommendation. However, the Bank is given "primary operational responsibility" for financial crisis management. In the crisis in 2007-08 there was little effective corporate governance of the Bank's actions by its Court, and this MOU does not mention the Court either. The main conduit for advice to the Chancellor will be the Governor himself. The MOU on co-ordination between the PRA and the FCA sets up arrangements for the two bodies to exchange information on individual firms. For wide-ranging issues that go beyond particular firms, the respective directors of supervision will be responsible for sharing information.[1765] There is a mechanism for escalating conflicts between the regulators ultimately to their boards, but not a mechanism for resolving such conflicts. The provisions of this MOU may not, in practice, solve all the problems that the evidence of two separate regulators may create.

1063. The effectiveness of the new structure will require good communication between the PRA and FCA to avoid duplication and unnecessary costs, as well as to ensure that supervisory issues do not fall between the gaps. Conduct issues, in particular, can have significant prudential implications, as demonstrated by the regulatory response to the mis-selling of PPI, where the scale of consumer redress has led to a weakening in banks' capital positions.[1766] Despite the formal Memoranda of Understanding, in practice, the effectiveness of the arrangements will rely on strong working level communication.[1767]

1064. 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.

1065. We have focused our consideration and recommendations in this chapter on:

·  The objectives of the regulators and the way these might shape their future work;

·  The accountability arrangements under the new regulatory structures; and.

·  The structure of enforcement decision-making;

Regulatory objectives


1066. The PRA has a statutory objective to promote the safety and soundness of firms. It is required to pursue this primarily by:

·  seeking to avoid adverse effects on financial stability; and

·  by seeking to minimise adverse effects resulting from disruption to the continuity of financial services that can be caused by the way firms run their business or by their failure.

1067. Unlike the FCA, which has an operational objective to promote competition, the PRA merely has a 'have regard' duty with respect to competition, namely to "the need to minimise any adverse effect on competition in the relevant markets that may result from the manner in which the PRA discharges those functions".[1768] The Treasury Committee, during the passage of the Financial Services Act 2012, called for the PRA to be given a secondary competition objective:

    It remains our view that competitive markets need both freedom to exit and freedom to enter. The Bill contains no proposal for specific objectives related to competition for the Prudential Regulation Authority. We recommend that the House of Lords consider amending the Bill to make competition an objective of the Prudential Regulation Authority.[1769]

1068. Witnesses fell into three camps. Some were in favour of a PRA competition objective, others felt a 'have regard' duty was sufficient and struck the correct balance, while a third group felt that even a 'have regard' duty would divert the PRA from its core objective, namely promoting financial stability. Sir Donald Cruickshank fell into the first camp. He warned that:

    If a regulatory body that is overseeing the activities of a sector of the economy that is central to the operation of the state does not have a competition objective—I am not talking about regulating doctors or nurses or indeed bankers themselves—it is very likely that competition will be muted.[1770]

Clare Spottiswoode fell into the second camp, but she acknowledged that a 'have regard' duty "may or may not be strong enough". In subsequent written evidence she stressed the importance of ensuring that the PRA's responsibility to act in a manner which minimised any adverse impact on competition was "strongly embedded in the culture of the PRA, from the top down".[1771]

1069. 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.


1070. The FCA's objectives have the appearance of having been designed on the hoof. They have certainly altered considerably from the Government's original July 2010 proposal for the establishment of a conduct regulator—at that time called, unhelpfully, the Consumer Protection and Markets Authority—with a single primary objective of "ensuring confidence in financial services and markets, with a particular focus on protecting consumers and ensuring market integrity", balanced by a set of statutory secondary objectives.

1071. The Government has subsequently greatly recast the FCA's objectives. The Financial Services Act 2012 now gives the FCA a single strategic objective of "ensuring that the relevant markets function well". This is buttressed by three operational objectives:

·  securing an appropriate degree of protection for consumers;

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

·  promoting effective competition in the interests of consumers.

The FCA must also, so far as is compatible with acting in a way which advances the consumer protection objective or the integrity objective, discharge its general functions in a way which promotes effective competition in the interests of consumers. The matters to which the FCA may have regard in considering the effectiveness of competition include:

·  the needs of different consumers who use or may use those services, including their need for information that enables them to make informed choices;

·  the ease with which consumers who may wish to use those services, including consumers in areas affected by social or economic deprivation, can access them;

·  the ease with which consumers who obtain those services can change the person from whom they obtain them;

·  the ease with which new entrants can enter the market; and

·  how far competition is encouraging innovation.

1072. The FCA was given an operational objective relating to competition only after sustained pressure from Parliament. The Treasury Committee, in particular, argued that the objectives of the FCA should be framed with a view to obtaining simplicity and clarity and expressed concern that "the so-called strategic objective adds nothing to the operational objectives, but may create scope for the operational objectives to be trumped".[1772] To date the Government has not shown a preparedness to reconsider this issue.

1073. Martin Wheatley, Chief Executive of the FCA, implied that the strategic objective added little or nothing to the three operational objectives:

    I am not sure that it [the strategic objective] does that much to the three operational objectives. You could argue that promoting effective competition in the interest of consumers and the market, enhancing the integrity of the system and ensuring an appropriate degree of protection encompass everything that is in the phrase "ensuring markets work well".[1773]

Mr Wheatley went on to tell us that he "would be open to a redrafting that keeps us to our core purpose, which is to get proper conduct standards in markets so that consumers get a better deal".[1774] Subsequently Mr Wheatley wrote to us nuancing the answer he had given in oral evidence:

    [...] the Government recognised that while the strategic objective should steer the FCA as to the overall aim it is trying to achieve, the operational objectives should be the means by which the FCA discharged its responsibilities. The 2012 Act therefore provides that the FCA should, so far as possible, advance its operational objectives, and act compatibly with the strategic objective. As a result, there are no powers in the 2012 Act which are triggered off the strategic objective—instead those powers can be deployed where the FCA considers it necessary or desirable to do so for the purposes of advancing any of its operational objectives.

    At the time the Government was considering the content of the strategic objective the FSA made clear that it would be concerned were the FCA to end up with an objective it could never fulfil. However, we are satisfied that the strategic objective as it currently appears does not leave the FCA exposed in that way.

    We also think that, as a statement of the overall outcome society expects of the FCA, the strategic objective is a reasonably good fit to the operational objectives.[1775]

1074. 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.


1075. We also received evidence which questioned whether the FCA would use its new competition powers effectively. A number of witnesses expressed concern that this was unlikely to happen. Sir Donald Cruickshank argued that the wording of the legislation in this area was flawed:

    I can tell you that if the Financial Services Bill becomes an Act in its present form, with that wording for the FCA relative to competition, it will have a minimal impact on the decisions of the FCA, because it is not a primary objective—it is qualified. Through that sentence, Sir Humphrey lives, because there are three qualifying phrases before the word "competition" is mentioned. In other words, if anything is clear, it is that you will make this objective subservient to any other objective you may possibly have, or consider that you have. That is how I would read it. It is not far short of saying just "have regard to".[1776]

We asked competition economists about how seriously the FCA would take its competition remit. They expressed concern:

·  that the FCA would continue to use regulation and not competition as its primary tool;

·  that the FCA lacked a pro-competition culture; and

·   at the lack of people at the FCA with specialist skills in competition economics.

Clare Spottiswoode told us that she did not see much sign that the FCA was going to employ its competition powers:

    I do not see many signs that the FCA is taking this seriously, which I regret very deeply [...] The FSA, as it becomes the FCA, is in great danger of going in many ways and in many wrong directions, which is another reason why I pushed that [competition] duty so hard. I thought that it would force the FCA to act differently, but there is no sign of its doing so yet.[1777]

When asked how best to ensure that the FCA took competition seriously, she told us:

    By tackling the FCA and saying, "How are you tackling the competition duty and making sure that it is embedded in everything that you do? When you look at introducing a rule, have you looked at a competition way of creating a better outcome first?" It just does not think that way. It is not the way in which it appears to think. It is not that it is not willing; it is just that it does not have any people there who have ever worked in this area.[1778]

1076. Diane Coyle concurred. She told us that "regulators tend to regulate and they do not think about competition as a tool that they can use".[1779] John Fingleton also stressed this point: "when you run a competition agency, you are probably over-confident about the ability of competition to get results in markets, but when you are a regulator, you are probably over-confident about the ability of regulation to solve every problem". Mr Fingleton went on to argue that:

    What you want in a sector regulator is very strong incentives to use the market and to use competition first to achieve the objectives and to back that up with regulation where needed. It is very important that the FCA sees competition as a positive tool that will achieve all of its other objectives rather than simply as a residual matter at the end of having regulated the market—"Well, do we have enough competition?"

    It is that fundamental change in attitude from what the FSA has done that is going to be essential if the FCA is to achieve its objective. The way forward document, the one with the funny name that was put out in November, used some of the right language, but I also detected in there a sense in the FCA that there might be a tension between consumer protection and competition. In fact, for the most part, they are complementary. Exploiting those complementarities and seeing them will be important. I think that the competition duty is important, as is getting it inside the culture of the organisation. There is a huge challenge for the leadership of the FCA to create that skill set and that attitude inside an organisation the historical culture of which has been to regulate rather than to think about how you get competition to deliver your objectives.[1780]

1077. Mr Wheatley defended himself against accusations that the FCA did not take competition seriously, telling us that "Well, she [Clare Spottiswoode] is correct in terms of signs. There may not be visible signs, because we are in the process of building a capability. Until we have built some capability we are not doing a lot of things very actively in the market to use that competition power".[1781] The FCA's chairman John Griffith-Jones told the Treasury Committee that the FSA had not previously had a competition objective, and that the FCA would therefore have to concentrate to make sure that competition objective was given as much attention as the others.[1782]

1078. 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 must—as a matter of priority—embed a robust pro-competition culture which looks to competition as a primary mechanism to improve standards and consumer outcomes.

Regulatory accountability


1079. One of the themes of our work, and one of the crucial lessons from recent as well as less recent history, is that the good intentions of regulators can fail to translate into a consistent pattern of action when faced with pressure particularly from within the banking sector and outside. This happened at times during the early stages of the crisis, as was noted in the Treasury Committee Report The run on the Rock, which referred to "a significant failure of the Tripartite arrangements" in September 2007.[1783] 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.

1080. The new regulatory structure is considerably more complex than the previous one, principally because of the substantial additional responsibilities given to the Bank of England, with the creation of the FPC and the PRA. The former is a sub-committee of the Court, and the latter a subsidiary of the Bank itself. This new structure creates challenges for the governance of the Bank. It also requires improved accountability structures that take account of the new structures.

1081. The financial crisis has highlighted the need for greater transparency to ensure that the regulator can be held to account, not least because it may help to counter the long-run pro-cyclicality of regulation to which we referred in Chapter 9. Andrew Bailey has acknowledged that the financial crisis provided a stark reminder of the public interest in the performance of banks and that the Bank/PRA will "need to explain its decisions more fully to Parliament than has been the case with some regulators, for example the Financial Services Authority"[1784]. He noted in written evidence that:

    [...] in spite of confidentiality concerns, there will need to be much greater transparency than in the past. All participants will need to live with this and accept that the world will not be the same again. That said, there are of course limits to transparency where commercial confidence is at issue, and indeed there are other legal requirements that limit open disclosure. I would therefore suggest that the Committee considers how it could take evidence in confidence.[1785]


1082. Although there have been substantial increases in the Bank of England's responsibilities, its corporate governance remains largely untouched by reform. Despite the creation of the new Oversight Committee—a sub-committee of the Court of the Bank of England—which is discussed below, the Bank's governance structures remain well short of what is expected in a modern institution, whether in the public or the private sector.

1083. The Governor of the Bank's own central position is greatly enhanced by the Financial Services Act 2012. He now also chairs the Financial Policy Committee and the Prudential Regulation Authority. The Bank's hierarchical structure, with him at the apex, remains—even if the new Governor, Dr Mark Carney, were to bring a more consensual leadership style, successors may revert to an autocratic style if the structure remains unchanged. The Governor remains a single institutional point of systemic risk in the governance arrangements.

1084. The MPC's accountability to Parliament is laid down in remit letters from the Treasury to the Bank of England. For example, the most recent remit of 20 March 2013 states that "The Bank will be accountable to Parliament through regular reports and evidence given to the Treasury Committee."[1786]

1085. The FPC's accountability is "through its publication of the twice annual Financial Stability Reports (FSR) and evidence given to the Treasury Committee",[1787] which holds hearings with FPC members on their appointment and reappointment, and judges them against the criteria of professional competence and personal independence. It also hears oral evidence in public from FPC members, including on each occasion some external members, following the six-monthly Financial Stability Reports. New Governors and Deputy Governors also have appointment hearings with the Treasury Committee: in the case of the next Governor Mark Carney, this took place well before he took up his duties.

1086. The hierarchical structure and culture of the Bank, the wide-ranging power of the Governor, and the fact that Bank executives were in the majority on the MPC and the FPC, could give rise to the risk of 'groupthink' and a lack of challenge within the institution.[1788] The Committee made recommendations about the Bank's Committees, including that the MPC and FPC should both have a majority of external members.[1789] Even more importantly, it concluded that improvements to the governance of the Bank required the transformation of the structure and role of the Court of the Bank of England.

1087. The Bank of England has been governed, at least in theory, by its Court of Directors since it was established in 1694. The Court is responsible for managing the affairs of the Bank, other than the formulation of monetary policy, which is the responsibility of the MPC. The Court's responsibilities are set out in the Bank of England Act 1998. They include determining the Bank's objectives and strategy, and ensuring the effective discharge of the Bank's functions and the most efficient use of its resources. The Bank has a statutory objective to "protect and enhance the stability of the financial system of the United Kingdom". The Court, consulting the Treasury and the Financial Policy Committee, determines the Bank's strategy in relation to that objective.

1088. The 13 members of the Court are appointed by the Crown. There are four executive members: the Governor and the three Deputy Governors responsible for Monetary Policy, Financial Stability and Prudential Regulation. The remainder are non-executive directors, and currently include: the Chairman of Court, Sir David Lees, former Chairman of Tate and Lyle and former Chairman and Chief Executive of GKN; Sir Roger Carr, the Deputy Chairman of Court and Senior Independent Non-Executive Director, who is Chairman of Centrica plc; and Dave Prentis, the General Secretary of UNISON.[1790] The Court delegates to the Governor the day-to-day management of the Bank, including the discharge of statutory functions, while reserving certain key decisions to itself.[1791] Under present legislation, the Court of the Bank of England could never fully replicate the functions of a private sector board, given the exclusive policy responsibility given by statute to the MPC rather than to the Court.

1089. The central recommendation of the Treasury Committee's Report subsequently supported by the Joint Committee on the Financial Services Bill[1792] on the Accountability of the Bank of England was that the anachronistic Court of the Bank be transformed into a Board effective enough to exercise meaningful governance:

·  the Board of the Bank should be responsible for conducting ex-post reviews of the Bank's performance in the prudential and monetary policy fields normally not less than a year after the period to be reviewed. This would be consistent with avoiding second guessing at the time of the policy decision. The reviews should among other things enable lessons for the future to be learnt, on which the Court should be expected to form a judgement. There should be no presumption that the commissioning of a review implied that the episode or function in question had been badly managed: successes and failures should be reviewed alike. It would be a matter for the Board itself to determine when and how such reviews would be conducted, and into which issues. There should be the presumption that ex-post reviews would be published, except where confidentiality needed to be maintained, in which case it might be desirable for either a redacted version to be published or for publication to be delayed.[1793]

·  Board members be authorised to see all of the papers considered by the MPC and FPC, to ensure that informed monitoring of processes and management was possible by the Board; [1794]

·  The new Board be responsible for avoiding groupthink within the Bank, and for reviewing committee processes;[1795]

·  the new Board be responsible for responding to requests to the Bank for factual information from Parliament and the Treasury;[1796]

·  the Bank strengthen the staff support for the new Board by a dedicated, high quality staff containing the skills and experience needed to fulfil its oversight functions;[1797]

·  the new Board's minutes be published to a timetable similar to that of the MPC, subject to any specific concerns of confidentiality which the Chairman of the Board should raise with the Chairman of the Treasury Committee; [1798]

·  the Chairman of the new Board have considerable experience of prudential or financial issues;[1799]

·  in addition to experience in running large organisations and financial institutions, members of the new Board have expertise in prudential policy;[1800]

·  the new Board be reduced from a membership of twelve to one of eight, comprising the Governor, the two Deputy Governors, an external Chairman, and four other external members;[1801]

·  when the Board considered the Bank's annual budget, it be responsible for coming to an explicit view about both the level of, and changes to the allocation of, resources for all areas of activity, including the macro-prudential and monetary areas of work. It should provide public explanations of those decisions;[1802]

1090. These recommendations were subsequently supported by the Joint Committee on the draft Financial Services Bill, which concluded that:

    The evidence we received in the course of our inquiry indicated that the House of Commons Treasury Committee was right to conclude that the governance structures within the Bank need considerable strengthening. [...] We support the idea that the Court should be replaced by a Supervisory Board with expert members some of whom should have experience in prudential policy. The new Supervisory Board would be empowered to scrutinise work of its sub-committees and conduct retrospective reviews of decisions taken by the FPC. The reforms in the draft Bill give the Bank significant new powers in macro- and micro-prudential policy. These powers must be paired with reforms to ensure that clear accountability processes are in place.[1803]

1091. The response of the Government to the recommendations of these two Parliamentary Committees was half-hearted at best. The Financial Services Act 2012 created a new sub-committee of the Court, the so-called 'Oversight Committee', comprising the non-executive directors of the Bank. This will have the power to commission retrospective reviews of the Bank's performance to be carried out either externally or internally. It, rather than the Court as a whole, will be responsible for monitoring the Bank's response to, and implementation of, the recommendations of any review it commissions. [1804]

1092. The Government rejected Parliament's other proposals for governance of the Bank, including transforming the Court into a meaningful board of governance. It said that "In general, the Government considers that the governance of the Bank should primarily be a matter for the Bank itself".[1805]

1093. Although no statutory obligation is placed on the Court or the Oversight Committee to respond to reasonable requests for information from Parliament, that Committee's examination of the new Governor, Dr Carney, suggested that he would have no objection to such a duty being placed in statute.[1806] Scrutiny by Parliament may be more difficult without such an obligation. 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.


1094. The Treasury Committee's recommendations about the accountability of the FCA were that:

·  That the board of the FCA publish full minutes of each meeting;

·  That the legislation provide that the FCA Board be responsible for responding to requests for factual information and papers from Parliament;

·  That the legislation provide that Parliament may request retrospective reviews of the FCA's work; and

·  That the legislation provide that the Chief Executive of the FCA be subject to pre-appointment scrutiny by Parliament.[1807]

Of these, the Government accepted only the first: the FCA has a duty under the Financial Services Act 2012 to publish the record of the meetings of its board.[1808]


1095. It is important that reviews are not only conducted in response to bank failures. This is particularly so because the PRA will not be operating a 'no failure' regime. Sir Mervyn King told the Commission:

    I don't think we want to have reviews only when there are failures of banks because we don't regard the failure of a bank as in and of itself evidence of a regulatory failure. We are not going to operate a no-failure regime. So we need some reviews of where there aren't failures: "Has supervision been adequate?" and so on. So it is very important that we do not equate failure of a bank with a regulatory failure from the outset. That would be a serious mistake. [1809]

Regulatory successes and 'near misses' will also be worthy of retrospective review.

1096. The absence of arrangements to ensure inquiries, whether internal or external, into past bank failures, such as those of Northern Rock, RBS and HBOS, was a serious weakness of the regulatory and governance arrangements. Many of those weaknesses remain in the new structure. They were or are being conducted by the FSA and were initially narrow in scope, concentrating largely on enforcement. In the case of RBS, the publication of any official report on the whole story of why the bank failed and what role the regulator played came only after intervention from Parliament: initially the FSA published just a 300 word press release at the end of its enforcement investigation. The FSA's report on RBS—published at the end of 2011[1810]—led to the FSA agreeing to produce a further report on the failure of HBOS, which is now being prepared. Andrew Bailey told the Commission:

    I think the key point is that the model that was adopted, which, as you say, started with the Northern Rock investigation, was for the FSA to investigate itself. To me, that is a difficult model which is always likely to end up where it did, which is people then calling into question banking and the validity of it and it being, in a sense, reset, as it was particularly with RBS.[1811]

1097. Sir Mervyn King told the Commission that, although the Oversight sub-committee of the Bank would authorise and commission inquiries, they would be conducted by an external party. Sir Mervyn King explained the reasons for this:

    [...] during the creation of the PRA we spent a lot of time talking to supervisors, both former supervisors in the UK and elsewhere, about the right model for supervision. One thing that struck me very forcefully talking to these people is that only one review of a bank failure episode commanded confidence among those involved. That was the Bingham inquiry after the BCCI failure. Why was that? Because Lord Justice Bingham was regarded as a person of unimpeachable integrity and was completely objective. He had no agenda of his own, no side, no particular issues to pursue, and he gave everyone a fair hearing. In my view, that is vital if you are going to have confidence in the process of holding an inquiry. You cannot have an institution like the PRA investigating itself, because one person in that institution will be asked to sign a document that is a report on the behaviour of other people in the same organisation. No one is going to believe that that is a fair process, and in large part, it will not be. It is very important to have these external inquiries, and that is exactly what the Bank will do.[1812]

He also believed that because the board of the PRA would be making major regulatory decisions, it would not be appropriate for the PRA board to undertake reviews, as the FSA had done in the past.[1813]

1098. When things go wrong in banks it is possible for both the bank itself—assuming it has survived—and the regulator to investigate what went wrong. It is good corporate governance practice for both of them to do so, in order that they learn from events. But only Parliament can hold the regulator itself to account for its actions. In the case of the failures of RBS and HBOS, the Treasury Committee has used the innovation of specialist advisers working inside the regulator in order to obtain an assurance that the regulator's report was a fair and balanced account.

1099. There remain problems with any investigation undertaken by or at the behest of regulators themselves or individual companies. The Swiss Government appointed Dr Tobias Straumann, an independent academic, to undertake a critical examination of the failures of UBS in investment banking and cross-border wealth management, and the resulting report, while addressed to the UBS Board, was arguably more hard-hitting than the reports on either the failure or RBS or the Salz Review.

1100. In April 2013, the FCA released details of how it will conduct investigations into regulator failures. This report noted that the FCA Board would oversee any investigation process and that the precise nature of this oversight (for example whether it is necessary to set up a sub-committee of the Board for the purpose) will depend on the circumstances of each case. The report notes that:

    Independence will be built into the process of conducting an investigation and producing a report. If necessary, parts of the investigation may be outsourced. Where investigations are not outsourced, they will be undertaken by (unconflicted) staff not part of the original events, and managed by areas not part of the frontline. Independent reviewers may be part of the process if necessary. [1814]

1101. The Financial Services Act 2012 creates a duty for the PRA to investigate possible regulatory failures where either public expenditure has been incurred or events have risked a significant adverse effect on the safety or soundness of a PRA-authorised firm.[1815] The Act also allows the Treasury to set up an independent inquiry into events with serious, or potentially serious, implications for financial stability or for consumers arising because of a failure in the system established by FSMA.[1816]

1102. The Financial Services Act 2012 gives the PRA a veto over the FCA where, in the opinion of the PRA, an action by the FCA may either threaten the stability of the UK financial system or result in the failure of a PRA-authorised person in a way that would adversely affect the UK financial system. The Treasury Committee was unconvinced of the Government's case for the veto, and believed that as a tool for maintaining financial stability, it ought to lie with the FPC rather than the PRA. It also said that any use of the veto would be an appropriate candidate for retrospective review.[1817]

1103. 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 RBS—which included an examination of the FSA's own role—was 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.


1104. 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.

1105. 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.

1106. 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 Bank—which includes the Bank's most senior executives—to fulfil the Bank's duty of accountability to the House. This is a serious weakness of the new legislation.

1107. 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 board—along the lines recommended in 2011 by both the Joint Committee on the Financial Services Bill and the Treasury Committee. The Commission recommends accordingly.

1108. 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.

The new responsibilities

1109. In this Report we have made a number of recommendations for new regulatory responsibilities, relating to:

·  Re-shaping the remuneration arrangements within banks;

·  Preparing and promulgating a Code for banking staff;

·  Establishing and operating a Senior Accountable Persons Regime;

·  Establishing a new registration regime for staff of banks who make decisions which bear risk but are not subject to the Senior Accountable Persons Regime;

·  Establishing a new register of bank staff within the Senior Accountable Persons Regime or in respect of whom relevant information is held in consequence of the licensing obligations.

1110. 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.

Physician, heal thyself

1111. 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.

1112. 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.

1113. 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.

Warnings from history

1114. As we said in Chapter 3, the regulatory authorities have repeatedly failed to learn the lessons of history; too many times in the past, no-one in authority has been prepared to challenge the economic orthodoxy and warn of the consequences of market excesses. The creation of the FPC, with its responsibility for monitoring and acting upon systemic risks with the purpose of promoting financial stability, has addressed this problem to some extent. It is designed to have the independence and authority to use its potentially significant powers of direction and recommendation. However, there have been recent developments that give rise to reservations about the FPC's independence and its ability to act in a counter-cyclical manner when necessary:

·  Not all external members of the interim FPC were reappointed to the permanent body. This gave rise to public discussion as to whether their service was being dispensed with for expressing opposition to aspects of Government policy;

·  The FPC will not be given the power of direction to vary over time the leverage ratio before 2018, and it will be subject to review in 2017 to assess progress with international standards—the Government is therefore reserving the right to delay transfer further;[1818]

·  The Chancellor wrote to the Governor on 30 April 2013 setting out: the economic policy of the Government for the FPC; matters that the Financial Policy Committee should regard as relevant to the Bank's financial stability objective; the responsibility of the Committee in relation to the achievement of that objective; and a series of recommendations to the FPC as to its responsibility in relation to support for the Government's economic policy, and matters to which the Committee should have regard in exercising its functions.[1819]

1115. We see merit in bringing further external views to the FPC and in reinforcing its focus on avoiding the mistakes of the past. 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.

1493   FSA, Annual Report 2011/12, pp 80 and 119,  Back

1494   Ev 1037 Back

1495   Speech by Sir Mervyn King at the Lord Mayor's dinner for bankers and merchants of the City of London, Mansion House, London, 15 June 2011  Back

1496   FSA Board Report, The Failure of the Royal Bank of Scotland, December 2011, p 254 Back

1497   Ibid., p 269 Back

1498   Q 4419 Back

1499   Written evidence from Andrew Bailey to the Treasury Committee, March 2013, p 13, Back

1500   FSA Board Report, The failure of the Royal Bank of Scotland, December 2011, p 264 Back

1501   Ibid. p 253 Back

1502   Speech by Sir Mervyn King at the Lord Mayor's dinner for bankers and merchants of the City of London, Mansion House, London, 15 June 2011 Back

1503   Letter to the Commission from a UK bank [not published] Back

1504   Written evidence from Andrew Bailey to the Treasury Committee, March 2013, p 10, Back

1505   Letter to the Commission from a UK bank [not published] Back

1506   EQ 93 Back

1507   EQ 155 Back

1508   Q 384 Back

1509   EQ 99 Back

1510   BQ 1074 Back

1511   EQ 92 Back

1512   BQ 1046 Back

1513   B Ev 179-180 Back

1514   B Ev 531 Back

1515   FSA Board Report, The failure of the Royal Bank of Scotland, December 2011,p 269 Back

1516   FSA, The Banking Conduct Regime, Back

1517   "All systems go as 'GI-Day' arrives", FSA Press Release FSA/PN/003/2005, 14 January 2005, Back

1518   EQ 111 Back

1519   J Ev 255 Back

1520   Q 4247 Back

1521   JQ 455 Back

1522   JQ 691 Back

1523   Bank of England, What is the FPC for? speech, Alastair Clark, 24 May 2012,  Back

1524   Letter to the Commission from a UK bank [not published]. Back

1525   Speech by Sir Mervyn King at the Lord Mayor's dinner for bankers and merchants of the City of London, Mansion House, London, 15 June 2011 Back

1526   FSA Board Report, The failure of the Royal Bank of Scotland, p 256 Back

1527   Letter to the Commission from a UK bank [not published] Back

1528   FSA Board Report, The failure of the Royal Bank of Scotland, p 256 Back

1529   BQ 1353 Back

1530   BQ 1354 Back

1531   Bank of England, The challenges in assessing capital requirements for banks speech, Andrew Bailey, 6 November 2012, Back

1532   EQ 22 Back

1533   Fourth Report, para 80 Back

1534   EQ 107 Back

1535   EQ 108 Back

1536   EQ 107  Back

1537   B Ev 252 Back

1538   Letter to the Commission from a UK bank [not published]. Back

1539   Ibid. Back

1540   PRA, Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 8 Back

1541   Ibid. Back

1542   FSA, Journey to the FCA, October 2012, Back

1543   For example see, Treasury Committee, Twenty-Sixth Report of 2010-12, Financial Conduct Authority, HC 1574  Back

1544   FCA, Industry guidance, Back

1545   Written evidence from Andrew Bailey to the Treasury Committee, March 2013, p 10, Back

1546  FSA, Speech by Sir Howard Davies to the Foreign Banks and Securities Houses Association Conference, 29 November 2001 Back

1547   Julia Black, "Making a Success of Principles-Based Regulation", Law and Financial Markets Review, vol 1, issue 3 (2007), p192 Back

1548   Letter to the Commission from a UK bank [not published]. Back

1549   PRA, Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 12 Back

1550   Ibid. Back

1551   PRA, Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 5 Back

1552   Treasury Committee, Fifth Report of Session 2012-13, The FSA's Report into the failure of RBS, HC 640, para 26 Back

1553   John Kay, Narrow Banking: The Reform of Banking Regulation, p 33, Back

1554   Response from the PRA and FCA to the Treasury Committee's Fifth Report of Session 2012-13, June 2013 Back

1555   PRA, Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 20 Back

1556   BQ 1421 Back

1557   EQ 79 Back

1558   PRA, Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 26 Back

1559   EQ 171 Back

1560   FSA, Journey to the FCA, October 2012, p 28, Back

1561   Q 3848 Back

1562   Letter to the Commission from a UK bank [not published]. Back

1563   Ibid. Back

1564   FCA, Business Plan 2013/14,25 March 2013, p 49, Back

1565   FSA, Journey to the FCA, October 2012, p 14, Back

1566   JQ 202 Back

1567   "'Be afraid' warns regulator Sants", BBC, 12 March 2009, Back

1568   "Martin Wheatley: FCA will 'shoot first and ask questions later", Money Marketing, 18 September 2012, Back

1569   Q 632 Back

1570   FSA, Journey to the FCA, October 2012, p 14, Back

1571   Q 3862 Back

1572   Q 3863 Back

1573   Q 3852 Back

1574   J Ev 255 Back

1575   JQ 386 Back

1576   Letter to the Commission from a UK bank [not published]. Back

1577   JQ 1  Back

1578   JQ 685 Back

1579   JQ 730 Back

1580   FSA, Journey to the FCA, October 2012, p 16, Back

1581   PRA, The Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 12 Back

1582   FSA, Journey to the FCA, October 2012, p 25 Back

1583   PRA, The Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 30 Back

1584   FSA, Journey to the FCA, October 2012, p 28, Back

1585   Q 3852 Back

1586   EQ 171 Back

1587   Bank of England, The challenges in assessing capital requirements for banks speech, Andrew Bailey, 6 November 2012, Back

1588   EQ 84 Back

1589   EQ 43 Back

1590   Letter to the Commission from a UK bank [not published]. Back

1591   J Ev 244 Back

1592   Q 4557 Back

1593   PRA, The Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 6 Back

1594   Q 2317 Back

1595   PRA, The Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 20 Back

1596   FSA, Journey to the FCA, October 2012, p 25, Back

1597   EQ 3 Back

1598   PRA, The Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 12 Back

1599   FSA, Journey to the FCA, October 2012, p 27, Back

1600   OCC, Policies and Procedures Manual, September 2011, p 4, Back

1601   Fourth Report, paras 70-71 Back

1602   Q 214 Back

1603   EQ 55 Back

1604   FSA, Journey to the FCA, October 2012, p 57, Back

1605   EQ 111 Back

1606   Q 3855 Back

1607   EQ 61 Back

1608   PRA, Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 38 Back

1609   Letter to the Commission from a UK bank [not published]. Back

1610   Ibid. Back

1611   Q 643 Back

1612   PRA, Prudential Regulation Authority's Approach to Banking Supervision, April 2013, pp 38-39 Back

1613   Written evidence from Andrew Bailey to the Treasury Committee, March 2013, p 10, Back

1614   Oral evidence taken before the Treasury Committee on 28 July 2010, HC(2010-12) 430, Q34 [Sir Mervyn King] Back

1615   Ibid. Q44 [Andrew Bailey] Back

1616   EQ 39 Back

1617   E Ev 43 Back

1618   EQ 126 Back

1619   Bank of England, The Dog and the Frisbee speech, Andy Haldane, 31 August 2012, Back

1620   Qq 4416-4417 Back

1621   Q 4417 Back

1622   Q 4416 Back

1623   Letter to the Commission from a UK bank [not published]. Back

1624   Bank of England, Annual Report 2012, p 36, Back

1625   Speech by Sir Mervyn King at the Lord Mayor's dinner for bankers and merchants of the City of London, Mansion House, London, 15 June 2011 Back

1626   PRA, Prudential Regulation Authority Regulated fees and levies: rates proposals 2013/14, pp13-14 Back

1627   Financial Services Act 2012, Arrangements for Counselling Practitioners Back

1628   Q 3856 Back

1629   Letter to the Commission from a UK bank [not published].  Back

1630   Q 3858 Back

1631   Q 3857 Back

1632   Bank of England, The Dog and the Frisbee speech, Andy Haldane, 31 August 2012, Back

1633   Ibid. Back

1634   EQ 48 Back

1635   Q 4513 Back

1636   C Ev 130 Back

1637   EQ 155 Back

1638   EQ 53 Back

1639   "Directives- definitions", European Commission, 11 June 2006,  Back

1640   "What are EU regulations?", European Commission, 25 June 2006, Back

1641   "CRD IV/CRR - Frequently Asked Questions", European Press Release MEMO/13/272, 21 March 2013, Back

1642   Ev 1607 Back

1643   Ibid. Back

1644   EQ 155 Back

1645   Q 4557 Back

1646   EQ 155 Back

1647   PRA, Prudential Regulation Authority's Approach to Banking Supervision, April 2013, p 24 Back

1648   First Report, para 237 Back

1649   Q 4589 Back

1650   Bank of England, Financial Stability Paper No.9: Whither the credit ratings industry?, March 2011, p 6, Back

1651   Financial Stability Board, Roadmap and workshop for reducing reliance on CRA ratings: FSB report to G20 Finance Ministers and Central Bank Governors, 5 November 2012, Back

1652   EQ 155 Back

1653   "Study fuels fears on bank safety", The Financial Times, 31 January 2013, Back

1654   Q 4512 Back

1655   First Report, para 294 Back

1656   Q 4320 Back

1657   Q 4323 Back

1658   Ev 895 Back

1659   HM Treasury, Dunfermline Building Society Financial Sanctions, Back

1660   "Financial Services Authority confirms Chelsea Building Society merger with the Yorkshire Building Society", FSA Press Notice, FSA/PN1050/2010, 19 March 2010, Back

1661   " Financial Services Authority confirms Norwich and Peterborough Building Society merger with the Yorkshire Building Society2, FSA Press Notice, FSA/PN1081/2011, 23 September 2011, Back

1662   Q 4510 Back

1663   Q 4513 Back

1664   Q 4511 Back

1665   EQ 155 Back

1666   Bank of England, The Dog and the Frisbee speech, Andy Haldane, 31 August 2012, Back

1667   Ibid. Back

1668   Ibid. Back

1669   EQ 8 Back

1670   Q 4320 Back

1671   Ibid. Back

1672   Parliamentary Commission on Banking Standards, Second Report of Session 2012-13, Banking reform: towards the right structure, HL Paper 126, HC 1012, para 74 Back

1673   The Government confirmed that interest on Additional Tier 1 and Tier 2 hybrid instruments would be deductible in the Budget in March 2013. See paragraphs 2.116 and 2.117 of HM Treasury, Budget 2013, HC 1033, March 2013, paras 2.116 and 2.117,  Back

1674   HQ 114 Back

1675   See IMF Staff Discussion Note, Tax Biases to Debt Finance: Assessing the Problem, Finding Solutions, 3 May, 2011,; IMF Working Paper, Debt, Taxes and Banks, February 2012,; IMF Working Paper, The Tax Elasticity of Corporate Debt: A Synthesis of Size and Variations, April 2011,; IMF Working Paper, Taxation and Leverage in International Banking, November 2012, Back

1676   See for example H Ev 312. Back

1677   Bank of England, Control rights (and wrongs) speech, Andy Haldane, 24 October 2011, Back

1678   Geoff Lloyd, Moving beyond the crisis - strengthening understanding of how tax policies affect the soundness of financial markets, July 2009, Back

1679   IMF Staff Discussion Note, Tax Biases to Debt Finance: Assessing the Problem, Finding Solutions, 3 May, 2011,; Geoff Lloyd, Moving beyond the crisis - strengthening understanding of how tax policies affect the soundness of financial markets, July 2009, Back

1680   HQ 1 Back

1681   H Ev 184 Back

1682   H Ev 172 Back

1683   HQ 178 Back

1684   H Ev 128 Back

1685   Q 4581 Back

1686   IMF Staff Discussion Note, Tax Biases to Debt Finance: Assessing the Problem, Finding Solutions, 3 May, 2011, Back

1687   Joint Hearing of US House of Representatives Committee on Ways and Means & US Senate Committee on Finance, President's Framework for Business Tax Reform, 13 July 2011, Back

1688   In Europe, Croatia, Italy, Austria, Latvia and Belgium have all implemented variants of an ACE. At present, Belgium, Brazil and Latvia continue to use a form of ACE. A recent tax committee of the Dutch government has also proposed an ACE - The Netherlands Ministry of Finance, Continuity and Renewal, Report of the Study Group on Tax Reform, 2010; IMF Staff Discussion Note, Tax Biases to Debt Finance: Assessing the Problem, Finding Solutions, 3 May, 2011,; H Ev 166. Back

1689   For a discussion, see HQ 14. There are a number of ways of calculating the allowance, for instance it could be based on the value of equity multiplied by a specific rate of return (possibly based on gilt yields). See also H Ev 160. Back

1690   Institute for Fiscal Studies, Mirrlees Review, 13 September 2011, Back

1691   See oral evidence taken before the House of Lords Economic Affairs Committee on 23 April 2013, Qq 1-4. Back

1692   H Ev 166 Back

1693   H Ev 167 Back

1694   IMF Working Paper, Debt, Taxes and Banks, February 2012, Back

1695   HQ 3 [Professor Devereux] Back

1696   See H Ev 166; Ruud A. De Mooij and Michael P. Devereux, "Alternative Systems of Business Tax in Europe: An applied analysis of ACE and CBIT Reforms", International Tax and Public Finance, vol 18, issue 1 (2011). Mooij and Devereux estimated the whole economy cost to be 0.3 per cent of GDP. Back

1697   See H Ev 247. Costs if available only to banks subject to the UK bank levy would be £0.8bn and £80m respectively. Back

1698   A full offset would require an estimated additional 5 basis points on the rate of the Bank Levy, taking it to 0.180 per cent. Alternatively, "offsetting the costs of the ACE through a higher rate of corporation tax may be a more logical approach." See H Ev 248; HMRC, Bank Levy Manual, BLM000500, 9 December 2010, Back

1699   H Ev 162 Back

1700   See paragraphs 176-1 80. Back

1701   Use of those IFRS which have been adopted into EU law is mandatory for the consolidated accounts of EU listed companies whose securities are admitted to trading on a regulated market. Back

1702   HQq 133, 309, 315 [Roger Marshall], 389; ICAEW, Audit of banks: lessons from the crisis, June 2010, Back

1703   The Pozen Report in the US noted that all valuation models are subject to reliability concerns, but that there are particular problems where a lack of quoted prices in respect of fair valuation leads to second-guessing. Advisory Committee on improvements to Financial Reporting, Final Report, 1 August 2008, Back

1704   Bank of England, Record of the interim Financial Policy Committee Meeting held on 21 November 2012, 4 December 2012, Back

1705   See for example, H Ev 92, 113, 132 Back

1706   H Ev 132 Back

1707   HQ 75. The expected-loss model is not yet part of IFRS-introduction of the accounting standard has been delayed by the EU adoption process.  Back

1708   HQ 131 Back

1709   H Ev 272 Back

1710   HQ 101 Back

1711   Oral evidence taken before the Treasury Committee on 15 January 2013, HC (2012-13) 873, Q 54  Back

1712  H Ev 140-141, 235, 294 Back

1713   Introduced in 2010. This replaced specific reference to 'prudence' with the concept of 'neutrality'. Prudence is argued to have been retained in the actual accounting standards themselves. See HQ 386.  Back

1714   H Ev 76 Back

1715   HQ 48 Back

1716   See, for example H Ev 105, 123, 141 Back

1717   Advisory Committee on improvements to Financial Reporting, Final Report, 1 August 2008, Back

1718   Q 3497 Back

1719   Treasury Committee, Eight Report of Session 2012-13, Appointment of Dr Mark Carney as Governor of the Bank of England, HC 944, Q 127 Back

1720   For a fuller discussion, see Bank of England, Accounting for Bank Uncertainty speech, Andy Haldane,19 December 2011, Back

1721   HQ 103 Back

1722   See FSA, Proposed Regulatory Prudent Valuation Return, CP 11/30, December 2011, p 5,  Back

1723   H Ev 175  Back

1724   "Benefits of IFRS far outweigh the loss of national standards", The Financial times, 29 March 2012, Back

1725   Ibid. Back

1726   HQ 402 Back

1727   FRC, Implementing the Recommendations of the Sharman Panel, January 2013, www, Back

1728   ICAEW, Audit of banks: lessons from the crisis, June 2010, p 11, Back

1729   International Auditing and Assurance Standards Board, Improving the Auditor's Report, 21 June 2012 Back

1730   HQq 108, 110 Back

1731   H Ev 230 Back

1732   The Sharman Inquiry, Going Concern and Liquidity Risks: Lessons for Companies and Auditors, Final Report and Recommendations of the Panel of Inquiry, June 2012,; H Ev 293, 335 Back

1733   H Ev 94 Back

1734   The French approach to audit requires auditors by statute to justify their assessments, or give reasons for the opinion issued. See, for example, H Ev 265; CNCC, Study on the perception of the statutory auditor's "justification of assessments", 3 May 2011, In Germany, the management report is audited alongside a review of the narrative part of the financial statements, which includes forward-looking information (H Ev 79). The Australian model requires a separate opinion on the Remuneration Report (IAASB, Feedback Statement - The Evolving Nature of Financial Reporting: Disclosure and its Audit Implications, January 2012). In the UK, the FRC has taken a different approach by focusing on the feedback loop between the Audit Committee and the external auditor and ensuring that both fulfil existing duties to the shareholders (see HQ152 and Financial Reporting Council, UK Stewardship Code, September 2012). Back

1735   Launched on 4 February, 2013. This covers commentary on 'risks of material misstatement', an explanation on 'materiality' and a summary of how the scope of the audit corresponds to disclosed risk. See FRC, Implementing the Recommendations of the Sharman Panel, January 2013, www, Back

1736   H Ev 91 Back

1737   Financial Services and Markets Act 2000, Section 12 (2); Disclosure of Confidential Information Regulations 2001 Back

1738   H Ev 174  Back

1739   H Ev 134, 211 Back

1740   H Ev 211 Back

1741   OECD, Addressing Tax Risks Involving Bank Losses,15 September 2010,; there are due to be changes in the way deferred tax assets (roughly speaking, stockpiled tax losses) can count towards regulatory capital in 2015. This paper also estimated that globally, the stock of bank tax losses was in excess of $700 billion. To the extent that deferred tax assets cannot be used for regulatory purposes, banks are likely to seek to convert them into cash benefit.  Back

1742   H Ev 112 Back

1743   H Ev 174 Back

1744   Economic Affairs Committee, Third Report of Session 2010-12, Auditors: market concentration and their role, HL Paper 119, para 155; also discussed in Chapter 3 of this Report. Back

1745   HQ 305 Back

1746   FSA, Code of Practice for the relationship between the external auditor and the supervisor, May 2011, Back

1747   PRA, The relationship between the external auditor and the supervisor: a code of practice, April 2013, p 2, Back

1748   HQ 94 Back

1749   HQ 306 Back

1750   PRA, The relationship between the external auditor and the supervisor: a code of practice, April 2013, p 4, Back

1751   HQ 205 Back

1752   HQ 209 Back

1753   ICAEW, Audit of banks: lessons from the crisis, June 2010, Back

1754   FSA and FRC, Enhancing the auditor's contribution to prudential regulation, June 2010, para 5.13, Back

1755   Ibid. Back

1756   HQ 298 Back

1757   EQ 71 Back

1758   FSA, The financial crisis and the future of financial regulation speech, Lord Turner, 21 January 2009,; Bank of England, Crisis and Crash: lessons for regulation, Michael Cohrs, 23 March 2012, Back

1759   Speech by Sir Mervyn King at the Lord Mayor's dinner for bankers and merchants of the City of London, Mansion House, London, 15 June 2011 Back

1760   Written evidence from Andrew Bailey to the Treasury Committee, March 2013, p 13, Back

1761   CentreForum, Macroeconomic policy: too much autonomy and too little coordination, August 2012, p 5,; Oral evidence taken before the Treasury Committee on 14 May 2013, HC(2013-14) 96-i,Q 277 Back

1762   Oral evidence taken before the Treasury Committee on 23 May 2011,HC (2010-12) 874, Q 143 Back

1763   "Federal Open Market Committee", Federal Reserve, 29 January 2013,; "Financial Stability Oversight Council", U.S. Department of the Treasury, 10 April 2013, Back

1764   "Memoranda of Understanding", Bank of England, 2013, Back

1765   The Lloyds insurance market and with-profits policies have more developed coordination arrangements. Back

1766   Bank of England, Record of the interim Financial Policy Committee Meeting held on 21 November 2012, 4 December 2012, p 5, Back

1767   Q 4429 Back

1768   Financial Services Act 2012, section 6 Back

1769   Treasury Committee, First Report of session 2012-2013, Financial Services Bill, HC 161, para 57 Back

1770   Q 154 Back

1771   Q 2330; Ev 1337 Back

1772   Treasury Committee, First Report of Session 2012-13, Financial Services Bill, HC 161, para 53 Back

1773   Q 4455 Back

1774   Q 4457 Back

1775   Ev 1249 Back

1776   Q 150 Back

1777   Q 2325 Back

1778   Q 2326 Back

1779   Q 2327 Back

1780   Q 2328 Back

1781   Q 4448 Back

1782   Uncorrected transcript of oral evidence taken before the Treasury Committee on 6 November 2012, HC (2012-13) 721, Q 3 Back

1783   Treasury Committee, Fifth Report of Session 2007-08, The run on the Rock, HC 56, para 276  Back

1784   Written evidence from Andrew Bailey to the Treasury Committee, March 2013, p 17, Back

1785   Ibid. p 16 Back

1786   Letter from the Chancellor of the Exchequer to the Governor of the Bank of England regarding the remit for the Monetary Policy Committee, 20 March 2013, Accountability is ensured by the following means:

New and re-appointed members of the FPC-both Bank executives and external members-are questioned upon their appointment, and the Treasury Committee publishes its conclusions as to whether it is satisfied with the individual's professional competence and personal independence;

The Committee hears oral evidence in public from MPC members following the quarterly Inflation Reports, when the Committee is able to question each member individually about their views and voting record. The Committee aims to see all MPC members at least once a year;

MPC members submit annual reports on their activities and views. Back

1787   Letter from the Chancellor of the Exchequer to the Governor of the Bank of England, 30 April 2013, Back

1788   Treasury Committee, Twenty-first Report of Session 2010-12, Accountability of the Bank of England, HC 874, paras 94-104 Back

1789   Treasury Committee, Twenty-first Report of Session 2010-12, Accountability of the Bank of England, HC 874, para 103 Back

1790   "The Court of Directors", Bank of England, April 2013,  Back

1791   Bank of England, Governance of the Bank including matters reserved to Court, 13 March 2013, Back

1792   Joint Committee on the draft Financial Services Bill, First Report of Session 2010-12, Draft Financial Services Bill, HL Paper 236, HC 1447, para 49 Back

1793   Treasury Committee, Twenty-first Report of Session 2010-12, Accountability of the Bank of England, HC 874, paras 81-82 Back

1794   Ibid., para 84 Back

1795   Ibid., para 102 Back

1796   Ibid., para 88 Back

1797   Ibid., para 71 Back

1798   Ibid., para 67 Back

1799   Ibid., para 52 Back

1800   Ibid., para 50 Back

1801   Ibid., para 54 Back

1802   Ibid., para 44 Back

1803   Joint Committee on the draft Financial Services Bill, First Report of Session 2010-12, Draft Financial Services Bill, HL Paper 236, HC 1447, para 309 Back

1804   Financial Services Act 2012, section 3 Back

1805   HM Treasury, A new approach to financial regulation: securing stability, protecting consumers, Cm 8268, January 2012, para B2 Back

1806   Oral Evidence taken before the Treasury Committee on 7 February 2013, HC (2012-13) 944, Qq 45-6 Back

1807   Treasury Committee, Twenty-sixth Report of Session 2010-12, Financial Conduct Authority, HC 1574, para 80 Back

1808   Financial Services Act 2012, Schedule 3 Back

1809   Q 4575 Back

1810   FSA Board Report ,The failure of the Royal Bank of Scotland, December 2011 Back

1811  Q 4574 Back

1812   Q 4575 Back

1813   Q 4577 Back

1814   FCA, How the Financial Conduct Authority will investigate and report on regulatory failure, 18 April 2013, para 710, Back

1815   Financial Services Act 2012, sections 74-76 Back

1816   Ibid., sections 68-72 Back

1817   Treasury Committee, Twenty-sixth Report of Session 2010-12, Financial Conduct Authority, HC 1574, paras 95 and 97; Treasury Committee, First Report of Session 2012-13, Financial Services Bill, HC 161, para 69 Back

1818   HM Treasury, The Financial Services Bill: the Financial Policy Committee's macro-prudential tools, September 2012, para 4.31 Back

1819   Letter from the Chancellor of the Exchequer to the Governor of the Bank of England, 30 April 2013, Back

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Prepared 19 June 2013