The new regulators:
Judgment, not tick boxes

More than a year after George Osborne announced the end of the old system of financial services sector regulation, the shape of its replacement is becoming clearer. Shayla Walmsley examines just how different the new system will prove to be.

Launching the new system of banking regulation, Chancellor George Osborne promises a “significantly different model of supervision”. Bank of England Governor Sir Mervyn King foresees “a new approach” based, the government insists, on “clarity of focus and responsibility, placing the judgment of expert supervisors at the heart of regulation”. How different is life really going to be?

Micro-prudential – firm-specific – regulation of financial institutions will come within the rubric of an independent subsidiary of the Bank of England, the Prudential Regulation Authority (PRA). The Financial Policy Committee (FPC) will be responsible, also from within the Bank of England, for macro-prudential regulation. The Financial Conduct Authority (FCA) will be responsible for “conduct issues across the entire spectrum of financial services”.

Cultures of competence

The objective of the PRA will be to minimise the adverse systemic impact of a single firm’s failure – not by protecting individual institutions but by ensuring they can fail without needing taxpayers’ help.

Led by current Financial Services Authority (FSA) head, Hector Sants, as a subsidiary of the Bank of England, the PRA plans to take “a judgment-led approach”. Says Chancellor Osborne: “We want to move away from the tick-box mentality of the current system, where there’s no shortage of costly regulation but too little room for invaluable judgment.”

Governor King has likewise pointed to a change in the style of regulation. “Process – more reporting, more regulators, more committees – does not lead to a safer banking system,” he says. For one thing, top-down regulation will replace lighttouch regulation. For another, what the PRA won’t do is tick boxes – a charge often leveled against the data-hungry FSA. “I believe that we can operate prudential supervision at lower cost than hitherto by reducing the burden of routine data collection and focusing on the major risks to the system,” says King.

“With the old system, one problem was that there was an awful lot of data and nobody was sure what was done with it so there was an issue about data for data’s sake,” says Jake Green, financial regulation partner at the legal group, Ashurst. “Now it sounds as though supervisors will be able to act on the basis of a feeling, rather than according to principles. But that’s not a negative move. It gives them more scope.”

The usual suspects

There are two potential difficulties with the emphasis on individual judgment. The first is that, to gain banks’ and public confidence, the regulator needs to ensure those exercising their judgment have the experience credibly to do so. One of the criticisms levelled at the FSA has been that its supervisors were often inexperienced and lacking nous, hence the over-focus on the clipboard.

The second is that it potentially understates the need for rules, as Julia Black, an LSE professor who specialises in financial services, suggests. “When the Bank of England last did the job in 1997 the global capital rules were minimal and so were the EU rules,” she says. “Now they run to hundreds of pages, which the Bank simply can’t ignore.”

Yet she supports the engagement of senior management, both of the Bank of England and the firms they are regulating, in the process of day-to-day supervision as “absolutely critical. I think they have got that right.”

The new regulation pares down the old FSA remit to hone a sharper focus on the likely danger spots. Pre-appointment interviews will be limited to senior managers, for example – a move welcomed by Green. The old near-ubiquitous pre-interviewing of senior bank staff was damaging on two counts, says Green.

First, it reduced the pool of talent by weeding out potential managers when it would have made more sense to widen the choice. Second, it made regulators into de facto recruitment interviewers for businesses. “Even now, I’m sceptical about how much can be done. If supervisors don’t like them, what happens? They never get a job again?” he wonders.

Former financial services secretary Paul (Lord) Myners points out that a more resilient banking system can’t be delivered by the regulatory architecture alone. “It depends on the people working within that structure. The government is right to talk about culture.” The PRA will take about 25 per cent of the FSA’s 4,000 employees.

Yet the focus of the new body will not simply be on getting the right people in the right places. It will also concern itself with ensuring cultures of integrity within financial institutions.

“It’s about how banks manage their brands as institutions. If you think about the impact of the oil spill on BP, it’s the same to the banking sector. How much does it behold shareholder value long term to think about the context of society’s broader aims, such as growth and diversity,” says Richard Reid, a former Citigroup economist and now research director at the International Centre for Financial Regulation.

The problem with regulatory ‘cultures’ is that they are no more immune from financial shocks than economies. Jacqui Hatfield, financial services regulation partner at Reed Smith, points out that over time people forget about the last scare, and new people arrive with no crisis experience. “Supervisors become laxer when economic times are good,” she says. “For the same reason, regulators need to ensure they supervise to the same extent in good times as in bad.”

The most important Basel 3 reforms are those relating to corporate governance, she adds. “If there is buy-in from the board about risk management, remuneration issues and stress testing, there is less likely to be another crisis. Regulations themselves will not change the pattern.”

Regulatory underlap

One new element in the new system will be a focus on integrating the regulatory agencies. Bringing the PRA and the FPC within the purview of the Bank of England is expected to overcome one of the major failings of the previous regulatory regime: “regulatory underlap”. This is where the linkage between same level and systemic stability issues had, according to the government’s white paper, “fallen between the institutional cracks.”

The danger, of course, is of unclear boundaries and even regulatory overlap. (Pre-appointment interviews, for example, will involve the FCA but will be led by the PRA.)

The division of labour – and more specifically authority – could become a much larger issue. Recent statements from the Chancellor suggest the FPC will call the shots because it is concerned with systemic risk. Osborne has called it the “central plank” in the new regulatory regime.

Housing them both under one roof will also demand a considerable cultural shift within the Bank of England, according to Myners. “Before, the Bank of England had one job to do – to set interest-rate policy – but the new regulator acquires a much more proactive, interventionist role,” he says.

In terms of cost-effectiveness, sharing the research resources of the central bank makes sense. Yet former MPC member Sushil Wadhwani and Myners have both suggested that this can result not in better alignment but in group-think.

Is there potential otherwise for overlap between the two agencies? Potentially, says Green, but not enough to concern him. “There could be an overlap with the other institutions, but the only thing that matters is that it works. There’s nothing that makes me think it’s a major problem.”

Once the legislation is in place by the end of 2012, the FPC will issue recommendations and directions to the PRA and the FCA on a comply-or-explain basis. It will also be empowered to specify the kind of action that it expects the other regulators to take.

The protocols for PRA intervention, reportedly inspired by the Canadian system, have yet to be worked out. But under the intervention framework the PRA could push though management changes, limit dividends or restrict business activities.

But Black points to a risk of less co-ordination, not more, between the new structures, day-today, when firms are jointly authorised, but also when it comes to strategic decisions. While the overriding trump card is financial stability, the procedures for the veto between the PRA and the FPC “is so laboured it is unlikely to be used except in cases of extreme disagreement,” she says.

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