Banking StandardsWritten evidence from the Financial Services Authority

1. The establishment of the Parliamentary Commission on Banking Standards is a welcome opportunity to consider the full range of factors which have undermined trust in the UK banking system and to assess the measures that can be taken to improve standards and restore trust. We welcome this opportunity to submit this Memorandum which addresses several of the issues raised in the Parliamentary Commission’s Terms of Reference. We summarise here the key points from our Memorandum.

Declining trust and Underlying Characteristics of the Banking System

2. We believe there are three reasons why trust in the UK banking system has declined:

First, the 2008 financial crisis has led to macroeconomic recession, unemployment and loss of income and wealth. As a result, people have come to doubt bankers’ competence and sense of responsibility.

Second, people have come to doubt bankers’ values and the recent LIBOR scandal has greatly reinforced this view.

Third, exploitative product sales, such as interest rate hedging products, have led many customers to doubt whether banks have their interests at heart.

3. In order to design effective policies to address these problems and restore trust, it is useful to recognise the three underlying characteristics of banking that differentiates it from other sectors:

The failure of banks can have consequences for the wider economy.

There is greater potential for customers to be exploited in financial services than in other sectors.

The inherent character of wholesale financial trading and sales activity often makes it very difficult to observe malpractice and therefore creates opportunities for it.

Measures in Hand Which Will Help Address the Problems

4. There are a series of measures that are already in hand that will help address these problems directly. Firstly, better prudential regulation and supervision will reduce the probability of bank failure and resulting macroeconomic harm. Second, the structural changes proposed by the Independent Commission on Banking (ICB) will both improve prudential soundness and create the potential for a change in culture and style which will help restore trust. Third, more effective conduct regulation and supervision, in both the retail and wholesale arenas, will seek to achieve earlier identification of emerging problems, thus reducing both the likelihood and severity of mis-selling problems. The incentives based culture in banking, which has been an important factor in driving conduct failings, will be a key area of focus and robust enforcement action will also remain at the centre of our supervisory approach.

Addressing issues of personal accountability, responsibility and culture

5. Rebuilding trust in UK banking will also crucially depend on changes in culture and improvements in values. The leadership of banks have a vital role to play in addressing this by setting the tone from the top. However, given the consequences bank failure can have on the wider economy, there are strong arguments for ensuring that bank directors face different personal risk return trade-offs than those which apply to other sectors of the economy. These issues are considered in the Government’s July 2012 consultation paper on “Sanctions for the directors of failed banks”. The full range of options considered in this paper will no doubt form an important part of the Commission’s deliberations. We welcome the “rebuttable presumption” proposal that a director of a failed bank is not fit to hold another senior executive or Board position at another bank. The Commission may also wish to consider whether any further reform of senior level remuneration structures has a role to play in improving standards and restoring trust.

6. Effective supervision is also important in encouraging an appropriate culture in banks that is filtered from the top downwards. Drawing on the lessons set out in our RBS Report on board effectiveness, the Prudential Regulation Authority (PRA) will expect senior management and boards to have a strong focus on the safety and soundness of a firm, expecting the firm to have sufficient controls and appropriate incentives in place to minimise the dangers of excessive risk taking. Likewise, the Financial Conduct Authority (FCA) will consider whether firms’ governance arrangements are adequate to enable the firm to identify and manage conducts risks in both the retail and wholesale markets. It needs to be recognised, however, that a supervisor’s ability to assess true commitment to appropriate values is highly imperfect. The Commission may therefore wish to debate whether other levers, such as professional or ethical codes of conduct in banking for instance, are available to improve standards.

Achieving better outcomes through effective competition

7. Competition is less effective in financial services than in other sectors; that creates the rationale for regulation and influence. Asymmetries of information and knowledge between consumers and providers and the fact that infrequent purchases and barriers to switching reduce the ability of customers to exercise market discipline via consumer choice. It is, therefore, vital that public policy seeks to make competition and customer choice as effective as possible. One of the FCA’s new objectives will be to promote effective competition that benefits consumers. This means it will step in when uncompetitive practices result in consumers getting a poor deal. This new supervisory approach could involve, for example, requirements for easier transfer between providers. A toolkit of clearly defined competition powers is required to underpin this approach and we support the recommendation put forward by the Joint Committee on the draft Financial Services Bill that the FCA be given market investigation reference powers1.

8. These issues are explored in more detail in our full memorandum.

PARLIAMENTARY COMMISSION ON BANKING STANDARDS

MEMORANDUM FROM THE FINANCIAL SERVICES AUTHORITY (FSA)

1. The establishment of the Parliamentary Commission on Banking Standards is a welcome opportunity to consider the full range of factors which have undermined trust in the UK banking system and to assess, in an integrated fashion, the measures which could be taken to improve standards and restore trust. We welcome the opportunity to submit this Memorandum which addresses several of the issues raised in the Parliamentary Commission’s Terms of Reference. We cover in turn:

(a)The reasons why trust has declined; and the underlying characteristics of the banking system which have contributed to that decline.

(b)Measures already in hand, in both prudential and conduct regulation and supervision, and via structural reform, which will help address the problems. We also identify here some specific cultural changes to the regulatory regime which will further enhance its effectiveness.

(c)Issues of personal accountability, responsibility and culture, alongside public policy initiatives in this area.

(d)Achieving better outcomes through effective competition.

(a) Declining trust and underlying characteristics of the banking system

2. The UK banking system plays a crucial role within our overall financial system and within the economy. Cost effective provision of high quality payment, deposit taking, insurance and credit products and services to household and business sectors is essential for a flourishing domestic economy. In addition, banking forms part of a UK wholesale financial services industry which provides services to the rest of the world, and which, as a result, creates income and employment in the UK. Many of the products and services sold are of high quality and there are many people working the industry who maintain high standards of integrity and professionalism.

3. It is clear, however, that trust in the banking system—in both its retail and wholesale aspects—has eroded and is now extremely low. We think it useful to distinguish three separate drivers of declining trust.

4. First, the financial and banking crisis of 2008 has led to macroeconomic recession, loss of income, wealth and unemployment. As a result, people have come to doubt bankers’ competence and sense of responsibility, and the economic benefits of increasing financial intensity and innovation. Before the crisis, people were told that many bankers merited very high pay because they were performing complex and important activities which contributed to increasing wealth. Now, and in many cases with good reason, they doubt that proposition. Part of the solution to restoring the trust must therefore be:

Policies that ensure that banking (and the wider financial system) do not induce instability, crisis and macroeconomic harm.

Policies which ensure that finance in future is focused on its valuable and essential activities, not on excessive risk taking or over complex product structuring of no value to society at large.

5. A second driver for declining trust is that people have come to doubt bankers’ values. The recent LIBOR scandal has greatly reinforced this view. While there is nothing new about dealing room culture, nor about market manipulation or insider dealing, what is new is that the sheer scale of financial activity has increased. Its share within the economy is much larger, and as a result, the potential size of corporate and personal benefit from malpractice has grown.

6. Third, direct household and SME experience of exploitative product sales, such as payment protection insurance (PPI) and interest rate hedging rate products, has led many customers to doubt whether banks have their interests at heart.

7. Policies to restore trust and raise standards need to address each of these three different dimensions. To design these policies effectively, it is useful also to identify the underlying characteristics of banking which create the potential for problems. Across all sectors of the economy, there could be opportunities for unethical or poor practice, for inferior quality product sales and for excessively high profit margins. But, in most sectors, we are able to rely on a combination of minimal regulation (eg. of product safety) plus the power of competitive forces, to limit any customer detriment. Financial services, but in particular banking, are different in three respects.

8. First, the failure of banks can have consequences for the wider economy which do no exist when a non-bank, such as a retailer or manufacturer, fails. This feature derives, in particular, from the role of banks as providers of credit and is to a significant extent specific to banks rather than financial institutions in general (though it also applies to some categories of shadow banking activity). As a result, as we argued in the FSA’s December 2011 report on the failure of RBS, society has an interest in ensuring that the executives and directors of banks make different decisions about the balance between risk and return than would be appropriate in other sectors of the economy2. This has implications both for:

appropriate prudential regulation and supervision (considered in section B below); and

incentives and sanctions which should apply to directors and executives of banks (considered in section C).

9. Second, there is greater potential for customers (in particular, but not exclusively, retail customers) to be exploited in financial services than in other sectors of the economy. This reflects (i) the asymmetry of information and sophistication between producers and consumers; (ii) the infrequency of purchase and the long lasting nature of some financial products; and, (iii) the barriers of inertia and of operational complexity which constrain customer switching between providers. Because of these features, customers are less well equipped to discipline providers through competitive choice than they are in other sectors of the economy. Furthermore, producers have greater potential to make excess profit through mis-selling, and greater temptation to develop business models designed to exploit those information asymmetries and switching costs. To overcome these problems requires some combination of:

Regulation and supervision to prevent the inappropriate design or sale of products.

Enforcement sanctions against exploitative mis-selling.

Culture change within banks so that boards and executives themselves voluntarily eschew opportunities for exploitation.

Reforms to make competitive forces and customer choice more effective.

10. Each of these four dimensions of policy is likely to be important; the crucial issue is the balance between them.

11. Third, the inherent character of wholesale financial trading and sales activity—in which profits are earned as a result of very small margins applied to massive volumes—makes it often very difficult to observe malpractice; and therefore creates opportunities for it. The “swaps dealer” element of the LIBOR scandal illustrates both the temptation and the challenge for effective policy response. Minute manipulations of LIBOR submissions by single basis points—which would be almost impossible to spot on the basis of market data analysis—have the potential when applied to enormous derivative positions to deliver large potential profits for individual traders. This problem is, however, not specific to LIBOR, but generic to much wholesale trading and sales activity. Insider dealing and market manipulation are notoriously difficult to prevent or observe—the victims are dispersed and unaware they are exploited, and the ability to spot the manipulation from market observation is imperfect. Policies to overcome these challenges need to combine:

Supervision and market scrutiny processes which, as best possible, identify problems, while recognising a trade-off between cost of supervision and effectiveness.

Supervision focused on ensuring that banks have in place effective internal compliance functions, which will themselves spot and constrain abuse.

Forceful punishment of offenders, with exemplary sanctions seeking to compensate for low identification and conviction rates.

Fostering corporate cultures which impose ethical constraints on behaviour even if supervision and enforcement is inherently imperfect.

12. In the sections below, we consider some of the actions already in hand and those which could be considered in future, to overcome these problems.

(b) Measures already in hand or planned

13. Much of the responsibility for improving standards and restoring trust lies with the leadership of banks, and we address in section C issues relating to the incentives which directors and top executives face, to culture and professional standards, and to the supervision of culture and governance. But changes to regulation and supervision which address the problems directly (rather than through influence on culture and incentives) will also play a crucial role. In particular:

Better prudential regulation and supervision will reduce the probability of bank failure and of resulting macroeconomic harm.

The structural changes proposed by the Independent Commission on Banking (ICB) will both improve prudential soundness and create the potential for a change in culture and style which helps restore trust.

More effective conduct regulation and supervision, in both the retail and wholesale arenas, will seek to achieve earlier identification of emerging problems, thus reducing the combined likelihood/severity of mis-selling problems.

Better prudential regulation and supervision

14. Effective prudential rules are an essential component of the regulatory structure. Ahead of the crisis, a flawed regulatory approach was marked across three areas: inadequate rules on bank capital and liquidity; failure to identify that credit and asset prices can be key drivers of instability; and institutional underlap between the Bank of England and the FSA. To a large extent, this has been rectified through the Basel III capital and liquidity standards; measures to ensure that all banks are resolvable; and the creation of the Financial Policy Committee (FPC), which will be responsible for deploying macro-prudential levers which can lean against excessive cycles in credit provision.

15. Crucially, this work will be supported by the supervisory approach of the Prudential Regulation Authority (PRA), which will build on the major reforms already introduced in the FSA over the last four years. Aligned with its safety and soundness objectives, the PRA role will be to make sure that firms are prudentially robust. The PRA will be forward-looking and judgement based, and will focus on those institutions and issues with the greatest potential impact on the stability of the UK financial system. Supervisors will intervene at an earlier stage, making judgements about current and future risks to a firm’s safety and soundness and about the action it should take to address these risks. Supervision will also be tailored to different firms and sectors; it will not be driven by a homogeneous approach but will vary according to risk.

16. Throughout the supervisory process, the PRA will engage with banks at a senior level, having conversations of a strategic nature, and holding information-gathering meetings, discussing analytical work and issuing detailed requests at a working level.

17. These changes to our prudential regulation and supervision framework aim to deliver a more stable system that people can trust by mitigating risk to our financial system at an earlier stage. However, this approach will need to be reinforced by changes in incentives and culture, which we will explore in section C.

Structural change through ring-fencing

18. Structural reforms, such as those recommended by the ICB, will also play an important role in delivering a more stable system and may provide an opportunity to rebuild customer trust.

19. Requiring critical banking functions to be ring-fenced from other banking services will help to ensure the continuity of these functions, whilst reducing the extent to which the government will be forced to bail out universal banks in their entirety in the future. This should help minimise excessive risktaking by reducing the implicit government subsidy and ensuring that funding costs more accurately reflect different risks on each side of the fence.

20. Increasing the loss absorbing capacity of ring-fenced banks (RFBs) should help to mitigate the risks of loss that these banks run. Ensuring that creditors can be bailed-in to bear losses in both RFBs and non-RFBs should also help impose greater market discipline on the banking sector and ensure that risktaking is not excessive.

21. In addition to these concrete prudential impacts of the ICB reforms, it is also worth highlighting that the emergence of ring-fenced banks may itself offer a major opportunity to rebuild customer trust; signalling a strong focus on the high quality provision of basic retail and commercial banking products. Grasping this opportunity, however, is likely to depend on a commitment by the banks to meet not just the letter but also the spirit of the ICB’s proposals. If this is successful, it may address the problems created by the coexistence of investment and commercial banking cultures under one roof. This may have implications for the appropriate governance of ring-fenced entities, which the Parliamentary Commission may wish to consider.

More intense and effective conduct regulation

22. Since 2008, the FSA has strengthened its supervisory approach, seeking to identify emerging threats at an earlier stage. In respect to conduct issues, the Financial Conduct Authority (FCA) will build on and further develop this approach in at least five ways.

Earlier intervention to prevent the mis-selling of unsuitable products to retail consumers.

Continued and enhanced use of our “Approved Persons’ Regime” to ensure high standards of both competence and integrity.

A strong focus on the impact of sales incentives on behaviour and culture.

An increased focus on conduct in wholesale markets, where in the past the FSA did tend towards a “caveat emptor” approach.

Continued robust enforcement action.

23. Earlier intervention and consumer redress. The FCA will build on this approach and will make greater use of our existing and new powers to intervene earlier to prevent the mis-selling of unsuitable products, such as PPI. It will also place more emphasis, at an earlier stage, on securing redress where consumers have suffered harm. The FCA’s approach will be underpinned by a new framework for supervision which will focus much more clearly on the main drivers of conduct risk at the firm and include both firm-based assessments and comprehensive market, sectoral and product chain analysis. The intensity of the application of the framework will depend on the FCA’s categorisation of the regulated firms.

24. Approved Persons, competence and integrity. The supervisory framework will be reinforced by our Approved Persons’ Regime, which will continue to take a risk based approach to pre-approving individuals to “controlled functions”. These “controlled functions” are those which involve persons exercising significant influence on the conduct of a firm’s affairs or those dealing directly with a firm’s customers. We set out through our Statements of Principle and Code of Conduct for Approved Persons (APER)3, standards of conduct with which approved persons must comply. Many employees, from main board directors to retail investment advisers, are already caught by this regime. In the future, both the PRA and the FCA will have the power to specify significant influence functions. In addition, the FCA will be able to specify customer functions.

25. The justification for requiring prior approval of certain individuals is that they are in a position, should they lack skill or integrity, to do serious damage to either the interests of customers and/or to the firm itself. Whilst the existing list of functions is broad, we expect that both the PRA and FCA may wish to review these over time, and to review their codes of conduct and standards, not least to take account of the findings of this Parliamentary Commission. An example of this could be those who submit information which is used to calculate LIBOR. Such individuals are not engaging in “regulated activity” and are therefore outside of the existing Approved Persons’ Regime. The Wheatley Review4 is currently considering whether and how the regime ought to be brought to bear on LIBOR related activities.

26. Sales force incentives, behaviour and culture. A further area of ongoing focus for the FSA, which will carry on into the FCA, is the incentives based culture in banking. This has been an important factor in driving conduct failings. We recently carried out thematic work on financial incentives of in-house sales forces across a sample of firms and sectors, including a number of high street banks. We assessed whether the financial incentives increased the risk of inappropriate selling and whether these risks were adequately controlled. At an individual firm level we found a number of incentive schemes that significantly increased the level of risk, which was not being adequately mitigated.

27. We are now working on the next steps, including taking action against firms where appropriate. We are also considering if new rules or guidance are needed to prevent high risk incentives structures. While the focus of our thematic work to date has been on the risks associated with financial incentives, we recognise that sales staff will also be influenced by the broader culture of the firm and how senior management define what is expected of them through, for example, targets and performance management. We have taken enforcement action against several firms where their approach to performance management contributed towards consumer detriment.

28. Increased focus on wholesale market conduct. One area where we expect the FCA to have greater focus is the conduct in wholesale markets between wholesale participants. It will give more weight to the fact that in many wholesale relationships there is likely to be a retail consumer at the end of the transaction chain and therefore recognise that what are, at first glance, activities involving wholesale participants often do matter to retail consumers. The FCA approach will recognise that poor wholesale conduct is not a victimless act simply because it takes place between sophisticated market participants. Neither is it limited to criminal behaviour like fraud or market abuse. It also captures a wide range of activities which exploit differences in expertise or market power to undermine trust in the integrity of markets or cause retail consumer detriment. An example is asset management where, through a range of intermediaries, many funds are managed for the ultimate benefit of retail customers.

29. Overall, wholesale markets can have a much wider impact on the integrity of, and trust in, markets than a narrow interpretation of the principle of “caveat emptor”5 may suggest. The FCA approach document, to be published in the autumn, will discuss some of the options to address poor wholesale market conduct in the context of how such behaviour might reveal some risk to the market.

30. Continued robust enforcement action. Over the last 6 years the FSA has greatly enhanced the effectiveness of its enforcement action using enforcement powers more robustly to address a wider range of conduct malpractice, and imposing more significant penalties. The PRA and FCA’s new approach to prudential and conduct regulation will require our enforcement team to work much more closely with supervisory and other colleagues in order to identify potential problems, and to enable us to use all of our tools promptly and effectively. Whilst our enforcement powers are largely effective, the Commission may wish to consider the case for further refinement across certain areas. This could include the following changes:

the ability to take disciplinary action against employees outside the scope of our approved persons regime;

the extension of the limitation period for taking action against approved persons; and

a power to prohibit an individual from performing a controlled function on an interim basis.

31. The case for possible change along these lines is set out in the Appendix.

32. Through these and other mechanisms, the FCA can seek to ensure that regulation and supervision play a strong role in constraining inappropriate behaviour and thus in requiring higher standards. But it is important also to note the limits of what regulation and supervision, in themselves, can achieve. It would be impossible for instance, to prevent all retail and wholesale malpractice in advance, without a massive increase in the scale of supervisory resource placing a disproportionate cost on the industry and as a result on the consumer. Rebuilding trust in UK banking will therefore also crucially depend on changes in culture and improvements in values, which in turn depend on the tone set by top management. We therefore consider in the next section what levers and incentives can encourage appropriate top management focus and tone.

(c) Addressing issues of personal accountability, responsibility and culture

33. The top management and boards of UK banks have a crucial role to play in improving standards and rebuilding trust. On the prudential side, the approach that they take to the balance between risk and return will have a major influence on the stability of the system. On the conduct side, the tone that they set and the priorities that they signal, will have a major influence on culture and behaviour throughout the organisation. This section therefore considers:

Measures to ensure that the directors of banks pay appropriate attention to downside risks of bank failure, or to other major prudential or conduct risks.

The importance of appropriate culture and the extent to which regulators can assess and influence it.

Whether there is a role for codes of conduct to encourage improvements in professional standards.

Addressing the risk return trade-off for directors of banks

34. In most sectors of the economy, a company failure is primarily a problem for shareholders and other private stakeholders (eg. suppliers and employees) but not for the overall macro economy. In contrast, a bank failure can have major adverse consequences for the whole economy. We therefore argued in our report into the failure of RBS that there are strong arguments for ensuring that bank directors face different personal risk return trade-offs than those which are appropriate in other sectors of the economy. We also explained in that report that there is neither in the relevant law nor FSA rules any concept of strict liability: the fact that a bank failed does not make its management or board automatically liable to sanctions. A successful enforcement case related to bank failure would therefore need to be based on clear evidence of specific actions by particular people that were incompetent, dishonest or demonstrated a lack of integrity.

35. In response to the FSA report on RBS, the Government issued in July 2012 a consultation document on “Sanctions for the directors of failed banks”. This considered the pros and cons of both:

A series of changes to regulatory rules which might better align risk and reward. It proposed in particular the introduction of a “rebuttable presumption” that a director of a failed bank is not fit to hold another senior executive or Board position at another bank.

The introduction of criminal sanctions for some categories of behaviour, based either on a concept of “strict liability” for bank failure, or on the proof of negligence, incompetence or recklessness. The consultation document was sceptical of the idea that a strict liability approach was appropriate, and noted significant complexities and difficulties in introducing criminal sanctions focussed on negligence or incompetence, but considered that recklessness might be an appropriate basis for a criminal offence of misconduct in bank management.

36. The FSA believes that the consultation paper is a useful starting point for the consideration of the different options, and we welcome the “rebuttable presumption” proposal. If this proposal were included in the current Financial Services Bill, it could send a clear message that bank senior executives and boards have a responsibility to ensure there is strong focus on downside risks. Clearly the consultation paper’s discussion of the full range of options will form an important input to the Parliamentary Commission’s deliberations.

37. One policy option not included in the Government’s consultation paper would be to adjust the reward structure of senior management and non-executive board members in order to encourage longer term focus and to ensure that senior executives and non-executive board members face personal consequences as a result of losses resulting from excessive risk taking. Considerable progress has already been made in the reform of incentive structures for top executive management, and the FSA is now enforcing the new remuneration rules introduced by the Capital Requirements Directive 3 (CRD3), which reflect principles established by the Financial Stability Board. It would be possible, however, to introduce still stronger rules in relation to executive management (eg. to lengthen the deferral periods) and/or to consider the extension of these principles to the remuneration of non-executive board members (eg. with fees deferred for several years and forfeited in the event of bank failure). The Parliamentary Commission may wish to consider whether any further reform of senior executive or non-executive remuneration structures has a role to play in improving standards and restoring trust.

38. Appropriate supervision can also play an important role in encouraging greater focus on downside risks. The PRA will therefore continue to assess board effectiveness on prudential issues, drawing on the lessons relating to board effectiveness set out in our RBS Report. It will engage with banks at a senior level throughout the supervisory process, having conversations of a strategic nature, and holding information-gathering meetings, discussing analytical work and issuing detailed requests at a working level. The PRA will also expect top management and boards to have a strong focus on prudential safety and soundness, and will expect that they will seek to satisfy the spirit as well as the letter of prudential regulations rather than game the rules for maximum short term advantage. It will expect a strong focus on ensuring that there is an appropriate culture, alongside sufficient controls and appropriate incentives in place to minimise the dangers of excessive risk taking throughout the organisation.

Supervision of culture and governance

39. Banks are only likely to earn the trust of customers if there is a clear message from the top that there may be business activities which are profitable but which the firm will not do because they go against its values, even if there were only limited risks that the regulatory authority would identify the problem and require redress and/or enforce sanction. For instance, if the top management and/or board of a retail bank observe very large profit margins being earned on a particular product line, they should be prepared to ask questions about whether the product is truly in their customers’ interest, rather than simply congratulate the relevant division and increase the sales targets.

40. Like the PRA, the FCA will therefore seek, as best possible, to ensure that firms’ top management and boards are acting in this way and that they are taking responsibility for establishing and maintaining an appropriate culture throughout the organisation. The FCA will therefore consider whether firms’ governance arrangements are adequate to enable the firm to identify and manage conduct risks in both the retail and wholesale markets. Where arrangements appear inadequate, the FCA may increase the scope of its firm assessment, undertake a deeper review of a particular area, or require the firm to strengthen systems and controls. It will also seek to assess whether candidates for significant influence functions have appropriate values, and have track records which illustrate appropriate focus on fair treatment of customers in past roles.

41. It needs to be recognised, however, that a supervisor’s ability to assess true commitment to appropriate values (as against the ability to say the right words) is highly imperfect. The Parliamentary Commission may therefore wish to debate how much reliance can be placed on externally imposed supervision in respect of the vital but somewhat “soft” issue of appropriate culture, and whether other levers are available to improve standards.

Culture and professional standards

42. In some sectors of the economy (eg. the provision of medical or legal services) society assumes that appropriate individual behaviour and organisational culture can be fostered through a commitment to “professional standards and ethics” which are to different degree defined and codified. All individuals who work in an authorised firm are required by the FSA to have the skills, knowledge and expertise necessary for the discharge of the responsibilities allocated to them. Individuals who carry out certain regulated activities for retail clients are also subject to detailed requirements in the FSA’s Training and Competence (TC) handbook. However professional competence does not in itself guarantee that those who possess it will use it in an ethical fashion and/or for the benefit of customers. The Commission might therefore wish to consider whether there could be a role for professional or ethical codes of conduct in banking, similar to those that exist in some other areas.

(d) Achieving better outcomes through effective competition

43. As mentioned in section A, competitive forces are less effective at disciplining firm and individual behaviour in financial services than in most other sectors of the economy. This reflects the asymmetries of information and knowledge between providers and customers, and the fact that infrequent purchases and barriers to switching reduce the ability of customers to exercise market discipline via consumer choice. To a degree, therefore, some combination of regulation and supervision, and of producer responsibility and ethical values, has to compensate for the ineffectiveness of markets.

44. Clearly, it is essential that public policy seeks to make competition and customer choice as effective as possible. One of the FCA’s new objectives will be to promote effective competition that benefits consumers. This means that it will step in when uncompetitive practices result in consumers getting a poor deal. Our regulation will try and encourage a market where the price offered is efficient and where firms’ entry and exit from the market is driven by consumers switching to those that offer the best combination of price, quality and variety. This new supervisory approach could involve, for example, requirements for easier transfer between providers.

45. To improve the effectiveness of regulation in this area, we believe the FCA needs a toolkit of clearly defined competition powers. We therefore support the recommendations put forward by the Joint Committee on the draft Financial Services Bill that the FCA be given market investigation reference powers, similar to those currently available to the Office of Fair Trading (OFT).

46. The current approach in the Financial Services Bill, which requires the FCA to make a public request to the OFT to consider using its market investigation reference powers, may lead to a disconnect between the FCA’s powers and expectations. It also risks leaving the FCA and the OFT with an overlapping remit on competition. This could lead to uncertainty and delay in challenging poor behaviour and securing better consumer outcomes. While we remain of the view that the FCA should not be responsible for dealing with breaches of the Competition Act 19986, we continue to believe that the FCA should have the full suite of market investigation reference powers, including the power to agree to undertakings in lieu of reference.

47. We look forward to engaging further with the Commission on the issues raised in our submission.

APPENDIX

ENFORCEMENT POWERS

1. In section B we explain that whilst our enforcement powers are largely effective, the Commission may wish to consider whether these need further refinement. In this appendix, we consider the case for possible change in three areas:

The ability to take disciplinary action against employees outside the scope of our approved persons’ regime.

The extension of the limitation period for taking action against approved persons.

A power to prohibit an individual from performing a controlled function on an interim basis.

The ability to take disciplinary action against employees outside the scope of our approved persons’ regime

2. It is worth noting that we have limited powers against individuals who are not approved. Whilst systems and controls and “tone from the top” are clearly key, it is obvious that a banking sector which functions well for consumers and the economy as a whole cannot be achieved unless employees below the level of senior management also act with honesty and integrity. Therefore, having the power to take action against individuals that commit misconduct, yet fall outside of the approved persons’ regime, could enable us to address existing limitations in this area.

3. We have also considered whether there might be any amendments to the provisions relating to official listings that could drive better behaviours across the financial services industry. At present, we can only take action against a director of a listed company if they were knowingly concerned about a contravention of the listing rules by the firm itself. Our experience suggests that the current definition of knowingly concerned7 is too narrow and positively disincentives directors from making enquiries to discover whether the listing rules are being complied with. We therefore suggest that the definition be amended so that enforcement action can be taken where a director “knew, or should have known” of the contravention.

The extension of the limitation period for taking action against approved persons

4. We believe there is a strong case for reviewing the time limitation period for taking action against approved persons. The period within which the FSA must issue a warning notice against approved persons currently stands at three years.8 This runs from the date that the FSA becomes aware of the offence, rather than the start of our investigation. There is an inconsistency between the treatment of individuals and regulated firms as there is no limitation period for breaches of the regulator’s rules by regulated firms. There is also no time limit for market abuse cases.

5. Our experience has been that three years is likely to be insufficient time for the PRA or FCA to determine whether there is a case to answer in complex cases, some of which may require information from overseas. This can include action taken against senior managers of large firms where the regulators will need to establish personal culpability on the part of those managers for their actions or omissions. Such cases often lead to the regulators having to obtain and process significant volumes of information, which can take a great deal of time.

6. The time limit can mean that the investigation into the individual’s conduct is truncated, making it more difficult for the regulator to pursue its case. In extreme circumstances, this can mean that if the regulator is not in a position to issue a warning notice within the three year time period then no action can be taken against the individual concerned. We would therefore urge the Parliamentary Commission to consider recommending the extension of the limitation period for taking action against approved persons.

A power to prohibit an individual from performing a controlled function on an interim basis

7. We also believe that a regulatory power to prohibit an individual on an interim basis from performing controlled functions would enable the FCA or the PRA temporarily to remove incumbent senior managers where they continue to pose a risk to the regulators’ objectives whilst the action against them is ongoing. We accept that this power would be a significant extension to our current powers, and that appropriate safeguards would need to be considered.9 However, this power would be a significant tool which would allow the regulators to act swiftly to counter any threat to their objectives by an approved person remaining in position pending an appeal.

6 September 2012