Chapter 7: Regulatory innovation, FinTech and the future
Areas where autonomy would be desirable
189.Some areas of the EU’s current regulatory framework have proved problematic in the UK context. The EU, according to UK Finance, “has always faced the challenge of regulating a market with an exceptionally diverse set of financial services businesses”,329 resulting in compromise solutions on legislation that are not always coherent when applied to domestic markets. Lloyd’s accordingly concluded that “the process of arriving at a level playing field can have disadvantages … Wide variations in regulatory approaches exist between jurisdictions.”330 Brexit may, therefore, present an opportunity for the UK to amend its regime in order to make it more fit for purpose.
190.The UK may also look to develop more innovative regulatory initiatives in order to reflect market strengths, rather than to rectify deficiencies in the existing regulatory framework. The UK is currently a world leader in FinTech, which, as we heard, had been fostered by regulators through projects such as the FCA’s regulatory ‘sandbox’.
191.Furthermore, financial markets are also capable of innovating through periods of disruption. As Professor Moloney put it: “They find a way … The history of financial markets is that they find solutions to difficulties … It may be that in so doing they make better, more efficient pipelines, products and technologies, using more efficient ways.”331
192.With respect to the current regulatory framework, the two concerns highlighted most often in this inquiry related to EU’s regime for insurers, and to the regulatory requirements to which domestic firms, often smaller, have been subject. We heard that there might be opportunities, post-Brexit, to tailor the UK’s regulatory regime so as to rectify these shortcomings.
193.We also heard concerns on the Interchange Fee Regulation; the second Payment Systems Directive; the MREL (Minimum Requirement for Own Funds and Eligible Liabilities) regime; MiFID II; bonus caps; the Short Selling Regulation; the Packaged Retail and Insurance-based Investment Products Regulation; the Deposit Guarantee Scheme Directive; and IFRS 9. We did not, however, receive enough evidence on these measures to reach a view on them.
Solvency II
194.There are areas of the UK regime that have incorporated EU standards in ways that may have been detrimental to the UK’s domestic market. Particularly highlighted by witnesses was the Solvency II regime for insurance, which establishes the amount of prudential capital that insurers must hold in order to reduce the risk of insolvency. Julian Adams of Prudential told us: “There are a number of aspects of Solvency II that not just the industry but the regulator does not think work appropriately.”332 Andrew Bailey concurred: “The problem with Solvency II is that it goes much more into the area of national retail markets.”333
195.The issue raised most frequently was the ‘risk margin’. This is an insurer’s additional capital requirement over and above the basic requirement, which serves as the extra capital a third party would need to take over and meet the obligations of the insurer in the event of its failure. Objections to the risk margin turn on the methodology used to calculate it, which is sensitive to long-term interest rates—in an environment with persistent low rates, the risk margin is substantial. Mr Adams told us: “Post Brexit, we would argue that that is a good example where an EU directive does not work appropriately for the UK, and we should have the policy freedom to change it.”334
196.The ABI also supported a review of the Solvency II regime: “Now would be an opportune time for the UK to review how the Solvency II regime is working in practice and see where there are opportunities to strip away some of the complexity and bureaucracy.”335 The risk margin was their chief concern: “Its size and sensitivity to interest rate movements are both significantly higher than expected and reflect unintended consequences of its design. This makes the writing of new business, in particular annuities and other long-term guarantee-based products, unattractive to firms.”336 Mr Adams confirmed that the risk margin requirement had had a direct effect on Prudential, which had withdrawn from writing individual annuities as a result.337 This concern was echoed in written evidence from the Equity Release Council, the Institute and Faculty of Actuaries, and Aviva.338
197.Andrew Bailey, asked about the appropriateness of Solvency II for the UK market, responded:
“The lesson I would draw on insurance is that EU regulation has been more effective when it has been directed at wholesale markets that operate across the Union in a fairly homogeneous fashion … The issue, particularly in life insurance, is that national markets in products are not homogenised across the EU, and there is no reason why they should be. Although it is changing with the pension freedoms, the UK has a history of using a much larger annuity market, for instance.”339
198.Some witnesses, though, did not favour substantial change. The London Market Group maintained that its “members believe that Solvency II’s fundamental principles are sound”, and that it “should continue to be the basis of UK insurance regulation”.340 This would both maintain regulatory alignment and avoid the costs of changing the regime. Bupa were even more forceful, stating that they “would strongly discourage any further major changes given that the insurance industry is still only now fully embedding Solvency II”.341 The Lloyd’s Market Association also “would not support an approach to insurance regulation in the UK which sought substantially to revise the existing regime, based on Solvency II. This would give rise to unnecessary costs and upheaval and would probably make it impossible to retain market access between the UK and the EU.”342
199.Some witnesses claimed that some of the problems with Solvency II were in fact a result of the UK’s ‘gold-plating’ of EU legislation. The insurance group Zurich claimed that UK regulation already went beyond what Solvency II strictly required, and were concerned that further divergence in regulation could “skew financial market activity to locations where rules were less onerous”.343 The Lloyd’s Market Association agreed: “There are areas where the UK’s regime imposes particular burdens on UK undertakings which are not based on EU legislation. An example is provided by Pillar III supervisory reporting.”344 The ABI and Aviva also claimed that some problems with Solvency II stemmed from the UK’s domestic interpretation.345 Such examples underline the flexibility that is already allowed in the application of EU rules.
Conclusions and recommendations
200.While there might be reason to change some aspects of Solvency II, the benefits of flexibility will in all cases need to be balanced against the possible consequences of regulatory divergence. The key issue raised in evidence to this inquiry was the risk margin. The Government and regulators should consider whether Solvency II requirements need to be updated in order to reflect the specificities of the UK insurance market, within the bounds of whatever agreement is reached with the EU on future market access.
Regulatory burdens on smaller firms
201.The second aspect of the UK’s current regime, as derived from EU regulation, that was cited as problematic was the regulatory treatment of smaller firms operating domestically rather than internationally. As the ICAEW pointed out, this has been especially problematic in the context of prudential standards, as “the approach to bank capital is an area where there have been differences between the international and EU approaches”. They explained: “The Basel Accord was originally intended for internationally-active diversified banks. In the EU (CRD IV, CRR) we have elected to apply the same Basel rules to all banking and investment firms. The US, in contrast, has not. It applies the Basel rules only to its international banks.”346 The Building Societies Association also noted that “for essentially domestic institutions, such as building societies, market access to other member states is less important”, and argued that the EU’s requirements for uniformity could be “costly and burdensome”, reducing competition and diversity.347
202.Some witnesses therefore advocated distinguishing between internationally-active institutions and domestic firms. The Building Societies Association argued that UK domestic retail firms and consumers could benefit from being able to follow a UK-only regime, as long as there was “simplicity and clarity for consumers”.348 The Equity Release Council, in the context of insurance rather than banking, said that it would be possible to “operate a split domestic regime, with a version of domestic requirements which has Solvency II equivalence, which domestic firms could choose to meet the requirements of if they wished to operate across the EEA, and a ‘core’ set of domestic requirements which would otherwise apply”.349 The Investment and Life Assurance Group similarly endorsed “a two-tier arrangement for firms that wish to market products and services in the EU and those who focus solely on the UK domestic market”.350
203.Andrew Bailey, of the FCA, also acknowledged that the Basel standards were designed for global cross-border banking groups, but that “the EU has chosen to implement Basel for all banks and building societies—credit institutions as they call them—irrespective of size, and to implement it in the same way”. The argument for flexibility had been put forward by the UK, but Brexit meant that the UK was now less well-placed to exert influence. Nevertheless, Mr Bailey hoped the issue would remain live: “The argument is still there, and, in principle, it would be nice to think that post Brexit we could have the scope for greater flexibility and proportionality.”351
204.Mr Bailey was keen, however, to differentiate between treating smaller domestic firms differently on the basis of proportionality and a formal dual regime. Under the latter approach, “We have one ring-fenced regime that points towards the EU and operates under EU rules … and the rest of the UK regime would do something different.” This would be “quite hard from a prudential point of view, because prudential regulation is whole-firm regulation … You have to be quite careful about those sorts of arguments … They are separate from the point you made about smaller, proportionality-type regimes.”352
205.Sam Woods also touched on the question of proportionality: “There is a question as to whether the practice we have had historically … of applying all the weight of everything to the smallest firms is sensible”, which he felt would in future be a question for both the UK and the EU-27. He continued: “That debate … is not, or should not be, in my view, about weaker standards for smaller companies. It is just a question of whether the full weight of the complexity, all the regulation, needs to apply to the very smallest companies, as well as the biggest ones.”353
Conclusions and recommendations
206.Basel rules were meant to apply to large cross-border institutions, and requiring smaller firms to comply with them may be unduly burdensome. Post-Brexit, it would be desirable for regulators to have the ability to apply any regulatory framework in a proportionate manner, where they judge this to be in the interests of consumers and the broader industry. The Government should consult on this once the terms of the UK’s access to the EU are agreed.
FinTech and innovation
207.FinTech is the application of digital technology to the provision of financial services. Developments in this area have the possibility of transforming the financial services sector and the products offered to consumers, radically altering the landscape and operation of the whole industry.
208.The UK has been at the forefront of industry and regulatory developments in the FinTech sector, as Deloitte highlighted: “The UK FinTech sector is going from strength to strength. It generated £6.6 billion revenue in 2015 and has a workforce of over 60,000 employees.”354 Neena Gill MEP suggested that this pre-eminence turned in part on London’s strength in finance more broadly: “The UK has been at the forefront in the development of the FinTech sector. However the continuation of its leading position will depend on whether London remains a main financial centre.”355 Charlotte Croswell, Chief Executive of Innovate Finance, agreed that the ‘ecosystem’ was critical, while also noting the strength of global competition: “We have financial services firms with FinTech firms sitting alongside; we have a regulator who has done some very progressive work on this, but we should not forget that it is a global competitive environment for talent.”356
209.The UK’s innovative approaches to FinTech regulation have served as a model for other regulators. In the words of Charlotte Crosswell, the sandbox “has been successfully copied across the world”.357 Funding Circle believed that “the UK approach to regulating direct lending platforms is a blueprint for other European countries to follow. For example, the Spanish and Belgian governments have examined the UK approach and subsequently introduced regulatory regimes for direct lending platforms in their own countries.”358 Catherine McGuinness, Policy Chairman of the City of London Corporation, reflected that she would “highlight the regulatory sandbox as an example of where we are ahead of a lot of the rest of the world and we have something to say very positively”.359
210.Witnesses highlighted several challenges posed by Brexit. One immediate concern was the probable loss of access to the European Investment Bank (EIB) and the European Investment Fund (EIF). Charlotte Croswell told us: “About 50% of the EIF fund goes to UK companies … so we definitely need a replacement source of funding.”360 Funding Circle noted that in 2016 alone UK small businesses gained £1.2 billion of investment from the EIB.361
211.Any loss of EU funding could be partially mitigated by the British Business Bank (BBB). Flora Coleman agreed that “the boosting of public sector funding for these initiatives needs to be maintained and the British Business Bank is the right funnel for that.”362 Charlotte Croswell elaborated: “We can expand British Business Bank resources with capital while reassessing qualifying activities for the EIF … It is something we need to consider quite urgently.” 363 Funding Circle noted that the BBB had lent £80 million to more than 15,000 UK small businesses through Funding Circle itself. The BBB was, however, restricted by EU state aid rules that placed limits on the amount it could lend through any one platform.364 Leaving the EU could allow the Government to remove this constraint, making it easier to support the sector. Charlotte Crosswell also noted that the BBB could be better tailored to address regional disparities across the UK: “To have something that also addresses the regional coverage of the British Business Bank is incredibly important, where again we have seen the dominance of London and the south-east.”365
212.The Minister, Stephen Barclay MP, noted that the Government had awarded an extra £2.5 billion of resources to the BBB as a response to the Patient Capital Review, representing a two-thirds increase in the scale of the Bank. Mr Barclay did not rule out continuing participation in the EIB, and stated that the Government recognised the importance of funding for FinTech: “We are also looking to ensure that either through the EIB or through equivalent funding we maintain what is seen as a key source of finance.”366
213.As Charlotte Crosswell told us, 40 per cent of FinTech firms are payment firms, meaning that the industry is “international from day one”. She therefore believed that the UK should remain part “of the single European payments area. That is available to non-EU firms, but only if we have regulatory convergence.” She also noted concerns in the sector “about passporting and Single Market access”.367
214.Deloitte highlighted the successful ‘FinTech bridges’ agreed with Australia, China, Singapore and South Korea, enabling the FCA to refer FinTech firms to other regulators and vice versa, and argued: “The UK and EU-27 should consider building a strong ‘FinTech bridge’ and co-operation agreement with the EU to ensure that, if something similar to passporting rights do not apply after Brexit, barriers to entry into each other’s jurisdiction remain as low as possible so that innovation and competition are not stifled.”368
215.As we noted in our December 2016 report, “The ability to continue to access highly qualified staff and the ability to transfer them between the UK and the EU is a key issue for the finacial services industry.”369 This is a particular challenge for FinTech. As Charlotte Crosswell told us: “There is a skills shortage in the UK, as we look to replace STEM skills through education and university.” She explained that 30% of Innovate Finance’s members were born overseas, and noted that “in Silicon Valley, 40% of tech workers, taken collectively, are non-US workers”. She believed this demonstrated that “entrepreneurs have choice of location; there are roles overseas that they can go to, so we have to continue to make the UK a friendly and easy place to do business so that they continue to want to work here”.370
216.The Minister acknowledged the importance of access to talent:
“You are absolutely right that talent is key within the FinTech sector. The Chancellor announced that the Government will be doubling the overall number of tier 1 exceptional talent visas from 1,000 to 2,000 and lifting the tech sector cap within that.371 The Home Office is also committed to looking at establishing sponsoring bodies outside London, and the Home Secretary will be inviting the tech community to help to design the system. We in the Government recognise the key importance of talents within the sector and that is why we are taking measures on this.”372
217.In our inquiry, Brexit: financial services,373 Daniel Morgan, formerly of Innovate Finance, alluded to the fact that the exceptional talent visa had stringent criteria and low awareness. He also stated, with respect to the entrepreneurial visa scheme, that “entrepreneurial talent does not have a definition”, and that there were significant barriers to obtaining visas, such as needing “a huge amount of capital already in place behind you”, or proving “that you are about to set up a business”.374 The Government’s current initiatives may therefore be insufficient to maintain the flow of talent required to sustain UK FinTech.
218.FinTech firms also rely heavily on data. The CBI emphasised that “the UK should also seek close alignment on policy issues that would impact the development of the FinTech industry such as the General Data Protection Regulation (GDPR), which has a material impact on the UK’s position as a leading digital economy”.375 This concern was echoed by Deloitte: “If the UK is not permitted to access or retain EU-27 customer personal data under the EU’s General Data Protection Regulation (GDPR), this will pose material challenges for firms that currently serve those customers, or hold data in offshore or shared service centres.” They argued that the seamless flow of data was particularly crucial for FinTech firms, a large number of which offered “tailored, personalised products” drawn from customer information. Deloitte therefore cautioned that “regulatory barriers to data flow may put UK-based FinTechs at a competitive disadvantage when trying to serve EU-27-based customers”.376
Conclusions and recommendations
219.The UK is a world-leader in the field of FinTech. One reason for this is its pioneering approach to regulation of the sector, and the regulators should be commended on initiatives such as the FCA’s ‘sandbox’ and the Bank of England’s ‘accelerator’, which capitalise upon their substantial expertise. Moves by the EU to legislate in this field should be resisted by the Government if they threaten the UK’s flexible and adaptive approach.
220.We also urge the Government to support the sector’s access to capital, given the potential loss of funds from the European Investment Bank. The Government should in particular strengthen the resources of the British Business Bank, not merely to replace the levels of funding offered by the EIB, but to increase UK firms’ access to venture capital overall.
221.The FinTech industry is reliant on access to skilled labour, as is the wider financial services sector. We call on the Government to consult with the sector in developing its post-Brexit immigration and visa policies, to ensure that the UK’s financial services sector, and FinTech in particular, can attract the best global talent.
The future role for UK regulators
222.Building on the UK’s innovative strengths will also require the regulators to be equipped with the right mandate and resources. Zurich commented that “neither the PRA nor the FCA has an objective relating to the competitiveness of the UK’s financial sector”.377 The ABI wanted this to change post-Brexit, suggesting that “regulators should have a new and explicit remit for UK competitiveness as part of their objectives, in both [a] European and global context”.378 The London Market Group expanded this point, noting that “such a competitiveness duty was previously included within the duties of the Financial Services Authority (FSA), and would require both regulators to have regard to the international competitiveness of the UK’s financial services sector in developing their regulatory positions”. They believed that “introducing such an objective for the FCA and PRA would also ensure that the UK is better placed to compete with other, growing international insurance hubs where the regulators do have international competitiveness duties, such as Zurich, Bermuda … and Singapore”.379
223.Barnabas Reynolds told us: “We need to look at whether our regulatory powers or framework should be tuned up again to the new environment by giving them an international competitiveness objective.”380 Julian Adams, while recognising that regulators rightly focus on safety, soundness and consumer protection, agreed:
“Brexit gives us the opportunity to ensure that we are comfortable with the objectives currently framed for the regulators … The Treasury Select Committee has recognised the argument we made for competition as a primary objective for the PRA, at least for insurance. There is a debate to be had about whether one wants to call it competitiveness, or the promotion of London as a financial centre, that could and should be part of a post-Brexit regulatory landscape.”381
Mr Adams stressed that this did not necessarily mean weaker regulation: “Competitiveness could be the promotion of the highest possible standards … I do not think it is a question of a race to the bottom, but you can promote London as a centre, and in a post-Brexit world that may be more appropriate and necessary.”382
224.The Minister, asked whether regulators’ remits could be amended, responded that the current regulatory framework had not precluded the UK’s ability to remain internationally competitive, mentioning the FCA’s sandbox and the UK’s work on Islamic finance and green finance. Although he acknowledged that the issue had been raised by the industry, he noted the forthcoming IRSG report on global competitiveness, and indicated his desire not to pre-empt its recommendations.383
Conclusions and recommendations
225.As the intensity of international competition facing the UK post-Brexit increases, it may become clear that regulators are unduly constrained by their current objectives. We recommend that the Government consider and consult on the desirability of adding a duty to promote international competitiveness to these objectives. Any change should be accompanied by strengthened Parliamentary scrutiny, given the potential trade-offs inherent in adding such an objective to the remits of the Bank of England and the FCA.
226.Whether or not the Government decides to add to the UK regulators’ remit, it is important that we engage with all of the pieces of the international regulatory jigsaw. Global competition and global regulatory standards-setting will become yet more crucial after the UK leaves the EU, and the Government should fight to ensure that the international regime for financial services continues to thrive. The Government must not squander the opportunity to enable UK financial services to become more outward-facing and access new markets, and should ensure that the regulators are appropriately equipped to oversee firms operating across borders.
338 Written evidence from Equity Release Council (FRS0017), Institute and Faculty of Actuaries (FRS0031) and Aviva (FRS0032)
369 European Union Committee, Brexit: financial services (9th Report, Session 2016–17, HL Paper 81) para 81
371 See European Union Committee, Brexit: UK-EU movement of people (14th Report, Session 2016–17, HL Paper 121), Chapter 3 for background on the UK’s tiering system.
373 European Union Committee, Brexit: financial services (9th Report, Session 2016–17, HL Paper 81)