Chapter 2: The origins of regulation and supervision
A multi-level regulatory system
13.The body of regulation affecting UK financial services derives from many sources. A cascade of regulation flows down from the overarching standards agreed in international bodies (such as the Financial Stability Board, or FSB), of which the UK is a part; from the EU, in which the UK contributes to shaping the laws that apply to EU Member States; from Parliament, by means of primary and secondary domestic legislation; and from the UK’s regulators, the Bank of England, Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA). The UK, as a member of the EU, is obliged to translate EU Directives (such as the Markets in Financial Instruments Directive, MiFID) into domestic law, and is also bound by EU Regulations (such as the Capital Requirements Regulation, the CRR), which are ‘directly applicable’.
14.Within the framework of EU law, the UK has some capacity to act independently. It can, to a limited extent, interpret Directives. It can also incorporate international standards directly where these do not contradict EU law. Finally, it can legislate in areas not covered by EU law (as has been the case with measures such as the Senior Managers Regime, which is an entirely domestic initiative).
15.In the words of Andrew Bailey, Chief Executive of the FCA: “In the world in which the FCA operates at the moment, there is a split between policy originated from the EU and policy originated domestically, which in itself falls into two categories; there are things that come out of domestic legislation in the UK and things that we do ourselves.”18 Lloyd’s made a broader point about the role of EU legislation in shaping the UK’s room for manoeuvre, when they stated:
“UK financial services legislation, the PRA Rulebook and the FCA Handbook are all heavily reliant on EU legislation. The regulatory rulebooks, in particular, contain 1,000s of references to EU Directives and other EU legislative provisions, to the extent that substantial portions can only be understood in the context of the EU legislation that they are implementing.”19
16.The Government’s aim is that, as a result of processes specified by the European Union (Withdrawal) Bill (see Chapter 3), the UK’s regulatory regime on day one of withdrawal is likely to look much the same as it does now (albeit with amendments to the supervisory framework, given that the UK will no longer be subject to the authority of EU institutions and agencies). But while the UK’s regime will from this point be within domestic control, the future scope for change will be limited both by the UK’s continued subscription to international standards, and by the precise form of any agreement reached with the EU (see Chapter 5). Sir Jon Cunliffe, the Bank of England’s Deputy Governor for Financial Stability, argued: “We must ensure that we maintain international standards that are implemented well in all countries. It is very important to the UK, particularly given our openness.”20 Andrew Bailey agreed, believing that in future it would be critical “that we do not become isolationist”.21
International standards
17.Professor Eilís Ferran noted that the common feature of international standards was that “they are non-binding. That enables them to be high level because they are not designed to be legally enforced.”22 The Personal Investment Management and Financial Advice Association (PIMFA) also affirmed that “the implementation of global rules is mostly subject to moral suasion”.23 As a result, the effect of international standards, once incorporated into national law, has not always reflected the intentions of their originators. The City Minister, Stephen Barclay MP, gave an example: “If you look at the original intention of Basel, it was for large systemic banks, and the regulation has been applied more widely than was originally intended.”24
18.International standards are more comprehensive in some areas than others (a list of the primary standards-setters is contained in Box 1). Professor Niamh Moloney, Professor of Financial Markets Law at the London School of Economics and Political Science, stated that international standard-setting tended to be concerned with “stability, risk management and prudential matters. It is increasingly beginning to look at conduct and investor and client-related issues, but, more often than not, issues relating to investor protection, consumer protection and conduct tend to be located in the EU or the UK”.25 TheCityUK, an industry advocacy group, also commented that “international standards on banking and prudential requirements are more developed than in other areas”.26
19.In particular, there are gaps in the regime for insurance, which led the Association of British Insurers (ABI) to comment that “unlike the Basel framework in banking, there are no global standards for insurance regulation”.27 Clifford Chance28 and Lloyd’s29 made the same point.
Box 1: International standards setters
20.While international standards have been influential in recent years, some witnesses cautioned that this might not continue in perpetuity. Professor Ferran said there was “a question mark over whether the international standard-setting fora are losing their influence anyway, in particular as a result of the ‘America First’ Trump presidency. There is a risk, if the US pulls out of serious commitment to those fora, of their becoming a talking shop without real bite.”30 Indeed, the Institute of Chartered Accountants in England and Wales (ICAEW) commented that politically-motivated delays meant that Basel III “has been nicknamed ‘Basel IV’ by some … We can no longer take for granted an international standard that describes a consensus of best practice agreed by leading nations.”31
21.Whatever their utility, witnesses were generally emphatic that the UK should not look to diverge from international standards. TheCityUK stated that global regulatory standards “minimise the risk of regulatory arbitrage and a ‘race to the bottom’ which may reduce consumer protection and increase systemic risk”.32
22.Influencing global standards may also be valuable in mitigating the UK’s loss of influence at the EU level. Mark Hoban, Chairman of the International Regulatory Standards Group (IRSG), stated that “in a post-Brexit world, that global regulatory framework becomes more important for the UK”.33 PwC argued that “playing a leading role in shaping global standards will be the best way for the UK to influence EU regulation post-Brexit”.34 Sir Jon Cunliffe commented that it would be of enduring importance to “influence the global debate”; he believed that “the Bank has a strong international reputation, and we intend to continue that and continue to invest in that”.35
The EU’s regime
23.The regulatory regime for financial services at the EU level has developed apace in recent years: starting from a relatively decentralised base, where much regulatory activity fell within the purview of the Member States, it has become complex, comprehensive, and increasingly centralised.
24.Perhaps the key feature of the EU’s regime is the pan-EU ‘passport’, which provides that “once a bank or financial services firm is established and authorised in one EU Member State, it can apply for the right to provide certain defined services throughout the EU, or to open branches in other Member States across the EU, with relatively few additional authorisation requirements”.36 According to the European Parliament, passporting “relies on two elements: i) a set of prudential requirements harmonised under EU law; and ii) mutual recognition of licences”.37 Box 2 summarises the key legislation granting passporting rights.
25.The list in Box 2 is not, however, exhaustive, as legislation granting passporting rights also covers insurance (the Insurance Mediation Directive and subsequently Insurance Distribution Directive); market infrastructure (the European Market Infrastructure Regulation, EMIR, allows clearing houses to offer services throughout the EU, and the Central Securities Depository Regulation, CSDR, does the same for central securities depositories); payment services (the second Payment Services Directive, PSD II, which applies from 13 January 2018, and the Electronic Money Directive); and mortgages (the Mortgage Credit Directive, MCD).
26.It should also be noted that there are other key pieces of the EU legislative jigsaw, which are based on international standards (such as the Bank Recovery and Resolution Directive, BRRD, which incorporates Financial Stability Board standards) that do not pertain to passporting.
Box 2: EU legislation granting passporting rights
Capital Requirements Directive (CRD IV)38The Capital Requirements Directive and the accompanying Capital Requirements Regulation came into force for banks in 2013, bringing into EU law the capital adequacy standards agreed at international level in the Basel III regulations. The CRD IV regime covers banking services, including deposit taking, lending and other forms of financing, financial leasing and payment services, some corporate finance advisory services and some trading services. There is no third country regime under CRD IV. Solvency II Directive39Solvency II sets the prudential framework for insurance and requires insurers to hold enough capital to have 99.5 per cent confidence that they could cope with the worst expected losses over a year. It allows an EEA firm to provide insurance or reinsurance services either cross-border or by establishing a branch in another state. Third-country insurers can provide services by establishing a branch within the EEA, authorised in the Member State in which it is established. A third-country equivalence regime exists under Solvency II for reinsurance but not for direct insurance Markets in Financial Instruments Directive (MiFID)40MiFID has been applied in the UK since 2007 and was recently revised. MiFID II and the accompanying Markets in Financial Instruments Regulation (MiFIR) came into force on 3 January 2018, although elements of the implementation have been delayed.41 Under the MiFID regime, banks and investment firms can passport services related to securities, funds and derivatives, including trade execution, investment advice, underwriting and placing of new issues and the operation of trading facilities. MiFIR introduces a third-country regime, allowing firms from third countries to offer these services cross-border to wholesale customers and counterparties. Undertakings for Collective Investment in Transferable Securities (UCITS) Directive42The UCITS regime has been in place since 1985 and was most recently updated in 2014. Investment funds that meet the rules set out under the UCITS Directive may be sold freely, including to retail investors, throughout the EEA on the basis of single national authorisation. There is no third-country regime under UCITS, so were the UK to become a third country UK-based asset managers wishing to continue marketing these products would have to re-domicile—though there could be scope for a redomiciled management company to delegate day-to-day management of the fund back to the UK. Alternatively, funds could be marketed to the EU from the UK as alternative investment funds (AIFs). Alternative Investment Fund Managers Directive (AIFMD)43The AIFMD sets the rules for alternative investment fund managers. It created an EEA-wide passport for EEA fund managers to market those funds across the EEA. A national private placement regime (NPPR) exists to allow non-EEA fund managers to market funds in EEA jurisdictions to professional investors, depending on the specific rules in those jurisdictions. AIFMD envisages that the NPPR will be phased out: it does, however, contain third-country equivalence provisions, which could enable UK firms to market their funds. |
Source: European Union Committee, Brexit: financial services (9th Report, Session 2016–17, HL Paper 81)
27.Evidence from the UK financial services industry expressed broadly favourable views of the EU regime. UK Finance, a pan-industry group representing nearly 300 firms providing finance, banking and payment services in the UK, stated that “the EU financial services regime, including its single rulebook, macro prudential, micro prudential and financial conduct framework has contributed significantly to the stability of the banking sector and the financial system in the UK and supports long term economic growth”.44 Barclays affirmed that “the breadth and depth of regulation has, over the years, created an environment that promotes stability, ease of cross-border activity, and economic growth”.45 Lloyd’s told us: “Our overall assessment of the EU’s financial services regime, in light of its application to the UK’s non-life insurance and reinsurance sector, is broadly positive.”46
28.As KPMG put it, “The EU’s current financial regulatory regime reflects three main drivers: application of commitments to global standards (most notably from the FSB, Basel Committee, IAIS and IOSCO); regulation to facilitate the operation of the Single Market; and rules to meet the specific needs of European financial markets where global standards do not exist.”47 A key impetus in recent years has been the need to shore up the financial services sector after the financial crisis, which led to a suite of EU legislative proposals, and the creation of the European Supervisory Authorities (ESAs) in 2011.48 According to Barnabas Reynolds, Head of the Global Financial Institutions Advisory & Financial Regulatory Group at the law firm Shearman & Sterling, another factor was that “a lot of rule-making in recent times has been focused on propping up the euro project”.49
29.Many of our witnesses felt that the recent period of intense EU rule-making was approaching its end. Current projects being undertaken by the EU include Capital Markets Union (CMU),50 shoring up the Banking Union, and the review of ESAs. Professor Niamh Moloney believed that the EU was now in:
“A steady-state procedure, so it is hard to see where the big new ideas would come from. The grand projects have been dealt with. We will see tinkering with banking union and finishing Capital Markets Union, but we will not see a big project over which there would be political contestation.”51
Andrew Bailey stated that from the perspective of UK implementation, “we are coming towards the end of what I might call the post-financial crisis regulatory reform agenda. We have a lot of big implementation on our hands in the next month or so, particularly with MiFID II. The pipeline does not look anything like as big as that, going forward.”52
30.We heard competing assessments of the future of CMU in the wake of the UK’s withdrawal. TheCityUK noted that CMU “could lose momentum in the short to medium term”, but added that “it is widely acknowledged that Brexit has only increased the need for this project to succeed”.53 The Confederation of British Industry (CBI) emphasised the UK’s “central role in the development of the CMU” (including the role of former UK Commissioner Lord Hill of Oareford).54 The EU has already announced initiatives such as a review of AIFMD, to be conducted under the auspices of the CMU project, which may have a bearing on the UK post-Brexit.
31.There are also significant legislative reviews currently taking place of the EU’s regulatory framework. These include measures on banking regulation (the Capital Requirements Directive and Regulation, CRD and CRR, and the Banking Recovery and Resolution Directive, BRRD) and the European Market Infrastructure Regulation (EMIR), most notably containing the possibility of imposing a location policy on systemically important central counterparties (CCPs).
32.On the current timetable, it appears that the UK will be part of negotiations on these initiatives, although its influence is waning. All will have important ramifications on the UK market: Deloitte’s written evidence argued that the EU’s proposals for the CRD “demonstrated a growing willingness to depart from implementing global post-crisis banking rules”, in particular by discounting risk weights derived from the fundamental review of the trading book (FRTB) by 35% for the first three years of application.55 The EMIR review is, as we have noted, a matter of concern for the clearing industry.
International standards and the EU
33.As we have noted, a number of EU rules derive from international standards and Neena Gill MEP portrayed the EU’s regime as proceeding “in line with minimum standards set on the international level”.56 Nonetheless, the high-level principles contained in international standards are not always transposed entirely faithfully into the EU’s own statute book; as Professor Eilís Ferran told us, “they are a starting point and EU regulation often comes out in a rather different form”. She gave the example of the IOSCO standards:
“They are quite high level and aim to be principles-based to set a standard that different jurisdictions can adhere to. If we compare that with the way in which the EU has imposed regulation on financial benchmarks, the EU has taken heed of international standards but has put in place a much more formalised regulatory regime requiring authorisation and registration, so there is quite a difference in the level of granularity between the two.”57
34.Barclays referenced the implementation of Basel III standards, where the UK had gone first, while “the EU is still in the process of implementing many standards and is proposing derogations from the Basel standard in areas such as the fundamental review of the trading book (FRTB) or Net Stable Funding Ratio (NSFR)”.58 Indeed, the EU’s prudential framework was in 2014 found by the Basel Committee to be ‘materially non-compliant’ with Basel standards.59 But while the EU regime is not always fully at one with international standards, Sir Jon Cunliffe’s summary was positive: “There have been some things that we have not necessarily agreed with … However, when you look at the international standards where they exist and how the EU has implemented them, it has been high quality.”60
35.Not all EU legislation flows from an international source. Sir Jon commented: “There is a lot of EU legislation in areas where there are not international standards, particularly in the market finance area—so legislation on hedge funds and the like.”61 TheCityUK criticised asset segregation rules in the Alternative Investment Fund Manager Directive (AIFMD) and Undertakings for Collective Investment in Transferable Securities (UCITS), and the Short Selling Regulation (SSR) on trading practices, as areas where the EU has taken unwelcome action, commenting that “the overlap of these pieces of legislation are a central cause of the reduced liquidity in the market but critically are not based on international standards”.62
36.There are also differences in the way that Member States transpose and operate EU law. According to Neena Gill MEP, “The UK is often accused of ‘gold plating’ by adding layers on top of European regulation, in order to adapt to the specific UK context.”63 TheCityUK’s evidence particularly singled out MiFID and MiFID II as examples of these practices.64 Gold-plating is often used as a pejorative term, and evidence from Zurich, the insurance group, correspondingly argued that “UK regulation is in many cases at a level that substantially exceeds international ‘norms’ and it is evident that the UK implementation of Solvency II by the PRA, has in some instances, resulted in a framework which is more complex and costly than necessary”.65
37.However, we also heard evidence that the UK’s practices of going beyond core requirements had often been effective: the assessment of the Financial Services Consumer Panel was that “the Government and FCA have often chosen to go beyond the minimum requirements of EU Directives” in order to resolve problems and “generate better consumer protection”.66 Charlotte Crosswell of Innovate Finance praised the UK’s history of innovating upwards on standards, commenting: “In the UK, we have a history of gold-plated standards. We have often led the way in asking people to adhere to higher standards than before.”67 Barnabas Reynolds, who was generally of the opinion that the UK should return to operating “higher standards with fewer rules”, was nonetheless unequivocal that “we should not get rid of the gold-plating”.68
38.While the UK has a history of over-implementation, Dr Kay Swinburne MEP told us in December 2017 that “17 member states do not even have the directive part of MiFID transposed into their national statute”—a fact she found “quite shocking”.69 The EU regime is therefore not uniformly implemented. The Financial Services Consumer Panel made a related point, suggesting that a “weakness of the EU regime has been a lack of consistent supervision across Member States. Regulatory expertise and resources across the EU28 vary greatly”, which in turn “creates risks for all consumers and undermines trust in the market, especially for passported products.”70
39.Furthermore, Professor Moloney stated that by virtue of its decision-making process, the EU’s policies may not always be optimal. One benefit of Brexit may be “a breakaway from groupthink about financial regulation. The EU is a monolith and it has big structures designed to produce compromise positions. That is not necessarily good for the global financial governance system”.71
The distinctiveness of the UK’s regime
40.In the wake of the financial crisis, the UK has been subject to a more developed regime at the international and EU levels. However, it has also had scope to initiate domestic legislation. Professor Niamh Moloney commented: “The UK has developed independently very sophisticated rules on banking accountability, in the Banking Act [2009], for example. All of those are distinct from what the EU has done.” She concluded that “the ethical/accountability framework … along with consumer protection” was being led at UK level.72
41.Jonathan Herbst, a Partner at the law firm Norton Rose Fulbright, highlighted a similar example: “The Senior Managers Regime, which is an entirely UK-created regime. Other countries have not followed it. No one seems to have a problem with that.”73 The ICAEW also praised the regime, commenting that “The UK’s Senior Managers Regime (SMR)74 has brought positive change in banks and their culture. It has brought a statutory and regulatory focus on individuals working in financial services firms.” The SMR shows the UK going beyond international or EU standards, which it is entitled to do within the bounds of the supranational regulatory framework. In such areas the UK can be a role model: the ICAEW noted that “other jurisdictions are observing how effective SMR proves to be and may seek to emulate it in due course”.75
42.The UK is also an international leader in FinTech, an area in which the EU is not much involved. Andrew Bailey commented that “FinTech, interestingly, is very little subject to regulation at the moment, and that is a good thing”.76 Flora Coleman of TransferWise noted that the regulatory sandbox,77 introduced as part of the FCA’s Project Innovate, was “being used to allow existing firms to try to push the boundaries of regulation in a highly supervised environment”;78 according to PwC, it had “demonstrated the FCA’s greater commitment to flexibility and supporting innovation compared to other regulators”. Rachel Kent, a Partner at the international law firm Hogan Lovells, also pointed to the sandbox, as well as the Bank of England’s regulatory accelerator, as evidence of the possibility of divergence within the existing regulatory system: “All those things have happened or continue to happen within our existing regime.”79
43.While the UK currently possesses a degree of autonomy in FinTech, which it uses to put in place innovative supervisory practices, there is the potential for EU intervention: Karel Lannoo, Chief Executive of the Centre for European Policy Studies, told us that “The EU is now working on a regulatory approach to FinTech. Is it needed? I do not know. It is a very limited industry size-wise.”80 Future EU activism in the area of FinTech may result in a more standardised regulatory regime being implemented within Europe; this may have future implications for the UK’s current supervision-led approach, depending on the outcome of decisions taken regarding future market access. There would be a risk to this industry if an agreement were to be reached that left the UK a rule-taker.
The UK’s role in shaping standards
44.The UK has played a significant role in shaping regulatory standards in financial services at both the international and EU levels. A report published in 2016 by the City of London Corporation and Norton Rose Fulbright, based on interviews with key participants in the negotiations, found that the UK had exercised significant influence over the final form of legislation such as Solvency II, AIFMD, EMIR, CRD IV and MiFID II.81
45.Professor Niamh Moloney reminded us that following Brexit the UK would lose access to many of the institutions through which it has hitherto exercised influence: “Those formal channels are the Commission, the European Central Bank and the European Supervisory Authorities that to a different extent sit on those bodies.”82 But the UK’s loss of access will also diminish those institutions themselves. As Mark Hoban, the former City Minister, commented, “The UK’s voice in ECOFIN on financial regulation was listened to because we have authority, expertise and a set of skills and experiences that others find it hard to replicate.”83 Daniel Maguire, Chief Executive of LCH, concluded: “It is imperative that the authorities of the UK sit at those tables and shape and influence the global regulation for these markets” post-Brexit.84
46.There have, though, been a few failures of UK influence at the EU level. One of the most notorious concerned remuneration rules in CRD IV, which impose a bonus cap for bankers. Deloitte noted that the UK had opposed this measure, on the grounds that it “fails to link risk-taking with variable remuneration, increases fixed pay at banks and consequently makes those banks less able to reduce their salary costs in times of stress, potentially contributing to financial stability risks.”85 Indeed, Karel Lannoo suggested that the UK might wish to take advantage of Brexit to change bonus rules,86 something that the Bank of England Governor, Mark Carney, has also hinted at.87 (The EU, however, has suggested that any equivalence ruling may be subject to the maintenance of such caps.88) The UK also opposed, without success, the Short Selling Regulation (SSR), on which, as the CBI noted, “the UK raised an objection in relation to the enforcement powers granted to ESMA”.89
47.Despite these occasional failures, the point stands that the UK has exercised significant influence as an EU Member State. In the absence of the UK, it is possible that the direction of EU legislation could shift. The ICAEW argued that “The UK, along with the Dutch, have been cited as the voice of ‘moderation’ at the EU ‘table’. There is now the risk that more polar views, or those that favour one or a small number of nations may be advanced.”90 UK Finance added that the “UK’s participation in negotiations has helped to avoid many of the unintended consequences that might otherwise flow from the lesser and more fragmented experience of financial markets regulation that exists elsewhere in the EU”.91 The future direction of the EU’s regulation may, therefore, become less fit for purpose for UK institutions than in the past.
48.Jonathan Herbst questioned “the popular perception … that the institutions of the EU will go in a more statist direction”. But, he added, “One of the big questions … is whether there will be enough expertise and market knowledge to do the job.”92 Simon Gleeson, a Partner at Clifford Chance, concurred, warning of what he called a “chained to a corpse issue”,93 if EU regulation did not keep pace with market developments, but the UK was required, under the terms of a free trade agreement, to ensure regulatory alignment (see Chapter 5).
49.International engagement will thus become even more crucial in future. In the words of Mark Hoban: “Once we are outside the EU, we will not have that opportunity to shape what happens in Brussels to the same extent, so the coherence of the global framework becomes important.”94 Sally Dewar of JP Morgan agreed: “The UK’s engagement and co-operation at international level is going to be even more important.”95 The London Metal Exchange also argued that, in the domain of financial market infrastructure, the most important factor would be “the convergence of UK and EU supervisory standards through the implementation of global standards.”96 Sir Jon Cunliffe commented on the Bank’s continued investment in shaping global regulatory work: “We need those standards; we need the strongest international governance relationships.”97
50.The UK has to date been influential in defining the international agenda at the highest levels, in particular through the work of the Governor of the Bank of England, Mark Carney. Mark Hoban, now Chair of the IRSG, commented “the UK plays a significant role in the shaping of global regulation as well as European regulation, and Mark Carney’s chairmanship of the FSB is a sign of that.”98 Andrew Bailey concurred: “The work that has been done by the G20 and the Financial Stability Board, which Mark Carney chairs, has been fundamental in putting stronger global standards in place.”99 Governor Carney’s term with the FSB has been extended until November 2018, with the ICAEW noting that he will also chair “two key BIS central bank groups … the Global Economy Meeting (GEM) and the Economic Consultative Committee (ECC)”.100
51.UK regulators have exercised technical influence over international organisations across a range of policy fields: as PIMFA noted, “Having UK regulators in positions of influence, in chairing global standard-setter working parties, groups and committees, and in exporting good regulatory thinking in their role as ordinary committee members, will be paramount … For instance, the FCA chairs IOSCO’s asset management work.”101 With respect to insurance, Lloyd’s commented: “UK supervisors are very active in the IAIS’s committee structure … and ensure that the IAIS’s views on regulation reflect experience in the EU.”102 The UK will need to continue to provide expertise across all tiers of international organisations in order to continue to retain influence.
52.Witnesses expressed concerns over the UK’s continued ability to exercise such influence in the future. In particular, change at senior levels in the regulators is expected: Mark Carney has announced his intention to step down from his role at the Bank of England in June 2019, while the first terms of appointment of Sir Jon Cunliffe, and of Ben Broadbent, Deputy Governor for Monetary Policy, expire in October 2018 and June 2019 respectively. Sir Jon Cunliffe assured us that “continuity in the Bank’s leadership” was “a very important issue in the Bank”.103 He also said that succession planning was a key issue for the Treasury, a point echoed by the Minister: “There are always times when senior figures change within institutions, but it is something we are alive to.”104 HM Treasury should make and communicate decisions regarding the occupancy of such senior appointments at the earliest possible opportunity.
53.Clearly, Government and regulators will need to be mindful of how domestic policies can contribute to a strengthened international presence. It is notable that, as Sam Woods told us, the PRA has imposed an additional levy to meet the demands of Brexit;105 the FCA have similarly increased their fees by £2.5 million this year.106 Regulators will need to address the challenges posed by withdrawal and will likely require yet further resources in order to do so.
Conclusions and recommendations
54.UK regulators have been highly influential at both technical and political levels within the international standards-setting bodies. The backbone of this engagement is personnel: without the right people in place, the UK will not be able to exercise the same clout. It is important that the UK’s financial services industry is reassured that regulators are adequately resourced and supported. The Government should, furthermore, take decisions about key leadership positions as early as practicable.
Risks of divergence from international standards
55.The financial services industry is concerned about the disruption that Brexit may cause to its business models and markets. From the perspective of regulation and supervision, however, the concern is ultimately whether withdrawal poses critical risks to financial stability. Sir Jon Cunliffe put this starkly: “What is important for us is financial stability. We are responsible for financial stability for probably the largest international financial centre in the world. It is 10 times GDP, and openness—and openness in financial services—can be and often is a good thing.”107
56.In the wake of the 2008 financial crisis, there were initiatives at the global and subsequently EU level to enshrine reforms that sought to prevent crises from re-occurring. Sir Jon Cunliffe summarised the scope of the reforms:
“The international standard-setting process existed for banks before the crisis. It now exists in a much deeper, more powerful way for banks, and for other areas of the financial sector: financial market infrastructure and the like. This whole idea of international financial stability is really what is at the heart of the Financial Stability Board, which tries to pull it together and push global standards.”108
He concluded that “international standards have made a very substantial contribution to reinforcing the system against those sorts of risks”,109 particularly in bolstering bank capital requirements and routing the clearing of derivatives contracts through CCPs.
57.Given the development of these post-crisis standards, there is a risk that Brexit could be used by the UK or the EU as an opportunity to row back on some of the commitments made as part of the post-2008 global reforms. The possibility of the EU instituting a location policy for CCPs, which would go against the grain of the 2009 G20 Pittsburgh commitments, was highlighted by our witnesses as a particular risk to financial stability, as it would cause the fragmentation of liquidity. Daniel Maguire, Chief Executive of the London Clearing House (LCH), stated:
“If you go down the route of fragmentation, you could have many pots of the same risk in many different jurisdictions, all trying to come in. You could have longs in one CCP, shorts in another, and so on. It can become very unwieldy. Going back to the G20 commitment thing, it is about safety, soundness and financial stability. The market is choosing that it is better in one place. The risk managers and the systemic risk managers think the same.”110
58.Brexit is being viewed on both sides of the channel as a threat to the financial stability the UK and EU have sought to embed. Sir Jon Cunliffe got to the nub of the issue: “Financial stability risk, to me, is about how institutions in one jurisdiction are exposed to another.”111 Supervising financial institutions within a more fragmented market will, for example, inevitably become more difficult and will rely on trust and cooperation.
59.Stephen Jones of UK Finance believed that if UK supervisors were “to take on the supervision of one large continental European bank’s £700 billion branch balance sheet in the UK, to do so without having undertaken the appropriate local supervisory protective measures could be seen as irresponsible”.112 Simon Gleeson stated that EU supervisors were also cautious about their ability to supervise institutions in their jurisdictions: “Europe has exactly the same view as the UK regulators on this. It will not allow brass plates; it wants to see real capital, real people and real business.”113 Fragmentation may undoubtedly create threats to stability, especially if underpinned by divergences from the international framework.
Conclusions and recommendations
60.The UK’s domestic regime for the regulation of financial services is largely, and increasingly, shaped by the context of international standards and EU law. The UK has been highly influential in shaping the form of supranational regulation, both at the international and EU levels. The UK has also shown leadership in areas of regulation in which it is not constrained by international standards, such as conduct and FinTech; these measures have subsequently served as models for other countries to follow. While leaving the EU may provide opportunities for the UK to tailor its regulation to domestic needs, such opportunities will be necessarily constrained by the UK’s continued participation in international fora.
61.It is imperative that the UK continues to devote sufficient resources to engagement with international standards-setters. The Government should continue, as a minimum, to adhere to international standards, and to work vigorously to shape them in future, especially if there is a risk of them being undermined by other states. It is crucial that such standards remain the base of the UK’s domestic regime, and that the UK acts to ensure that they are properly implemented worldwide.
62.The Government should also seek to develop new international relationships, to fortify the extant engagement taking place within formal standards-setting bodies and more broadly. This may include considering ways in which further cooperation can be sought within a bilateral context, including setting up joint fora to monitor regulatory developments. Embedding a network of global cooperation via these means could help to synchronise standards within and beyond the EU.
63.Post-crisis changes have served to promote financial stability and the Government should continue to advocate these reforms. This is especially the case if faced with initiatives by the EU that in fact lead to market fragmentation and a reversal of the post-crisis commitments—such as is the case with current proposals that would potentially require CCPs to relocate within the EU.
36 British Banking Association (BBA), What is ‘passporting’ and why does it matter? Brexit Quick Brief #3: https://www.bba.org.uk/wp-content/uploads/2016/12/webversion-BQB-3-1.pdf [accessed 12 January 2018]
37 European Parliament, Third-country equivalence in EU Banking legislation (12 July 2017): http://www.europarl.europa.eu/RegData/etudes/BRIE/2016/587369/IPOL_BRI(2016)587369_EN.pdf [accessed 12 January 2018]
38 The CRD IV package comprises Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (OJ L 176/338, 27 June 2013) (CRD) and Corrigendum to Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 (OJ L 321/6, 30 November 2013) (CRR)
39 Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance (OJ L 335/1, 17 November 2009) (Solvency II)
40 The MiFID II package comprises Directive 2014/65/EU of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Directive 2002/92/EC and Directive 2011/61/EU (OJ L 173/349, 12 June 2014) (MiFID II) and Regulation (EU) No 600/2014 of the European Parliament and of the Council of 15 May 2014 on markets in financial instruments and amending Regulation (EU) No 648/2012 (OJ L 173/84, 12 June 2014) (MiFIR)
41 ICE Future Europe and the London Metal Exchange were granted 30-month extensions by the FCA and Eurex was likewise granted a delay by BaFin. ESMA have also delayed publishing the list of equities to be excluded from trading in dark pools for three months, pending further technical work.
42 Directive 2014/91/EU of the European Parliament and of the Council of 23 July 2014 amending Directive 2009/65/EC on the coordination of laws, regulations and administrative provisions relating to undertakings for collective investment in transferable securities (UCITS) as regards depositary functions, remuneration policies and sanctions (OJ L 257/186, 28 August 2014) (UCITS)
43 Directive 2011/61/EU of the European Parliament and of the Council of 8 June 2011 on Alternative Investment Fund Managers and amending Directives 2003/41/EC and 2009/65/EC and Regulations (EC) No 1060/2009 and (EU) No 1095/2010 (OJ L 174/1, 1 July 2011) (AIFMD)
48 See European Union Committee, The post-crisis EU financial regulatory framework: do the pieces fit? (5th Report, Session 2014–15, HL Paper 103). Appendix 4 of that report provides an overview of the major legislative reforms undertaken at the EU level post-crisis. As the report summarises, some reforms, such as the Capital Requirements Directive (CRD) and Capital Requirements Regulation (CRR)—jointly known as CRD IV—and the European Market Infrastructure Regulation (EMIR), are closely associated with the G20 agenda. Others, such as the Alternative Investment Fund Managers Directive (AIFMD), reflect the EU’s own agenda. Some concern reforms to existing legislation, such as the revised Markets in Financial Instruments Directive (MiFID II) and Regulation (MiFIR). Finally, there are EU-specific institutional reforms, such as the Banking Union framework and the establishment of the European Supervisory Authorities (ESAs).
50 On which, see European Union Committee, Capital Markets Union: a welcome start (11th Report, Session 2014–15, HL Paper 139)
59 Bank for International Settlements, Regulatory Consistency Assessment Programme (RCAP) Assessment of Basel III regulations: European Union (December 2014): https://www.bis.org/bcbs/publ/d300.pdf [accessed 12 January 2018]
74 The FCA’s Senior Managers and Certification Regime replaced the Approved Persons Regime (APR) for banks, building societies, credit unions and dual-regulated (FCA and PRA regulated) investment firms in March 2016. The most senior people (‘senior managers’) performing key roles (‘senior management functions’) need FCA approval before starting their roles. Every senior manager needs to have a ‘statement of responsibilities’ that clearly says what they are responsible and accountable for. See Financial Conduct Authority, ‘Senior Managers and Certification Regime: banking’ (November 2017): https://www.fca.org.uk/firms/senior-managers-certification-regime/banking [accessed 19 January 2018]
77 The regulatory sandbox allows approved firms to test innovative business models without immediately incurring regulatory consequences, while remaining under close supervision by the FCA. Firms must apply to join the initiative; three application rounds have so far been held with the third cohort of firms announced in December 2017.
81 City of London Corporation, Shaping legislation: UK engagement in EU financial services policy-making (June 2016): https://www.cityoflondon.gov.uk/business/economic-research-and-information/research-publications/Documents/research%202016/shaping-EU-legislation-2.pdf [accessed 12 January 2018]
87 Caroline Binham, ‘Bankers’ bonus cap could be scrapped after Brexit, says Carney’, Financial Times (29 November 2017): https://www.ft.com/content/dea0611c-d51c-11e7-a303-9060cb1e5f44 [accessed 12 January 2018]
88 Jim Brunsden, ‘Brussels signals tough stance on UK bank bonuses after Brexit’, Financial Times (19 December 2017): https://www.ft.com/content/98c9a2b4-e4a0-11e7-97e2-916d4fbac0da [accessed 12 January 2018]
106 Emma Haslett, ‘Brexit will cost the financial regulator £2.5m this year’, City A.M. (18 April 2017): http://www.cityam.com/263030/brexit-cost-financial-regulator-25m-year [accessed 16 January 2018]