London’s Changing Market Regulation

Since the start of the financial crisis in 2007, England’s tripartite model of financial regulation—where the HM treasury, Bank of England and Financial Services Authority (FSA) shared responsibility for financial regulation—has been widely criticized for failing to prevent or adequately respond to the financial crisis.  Critics argue that the crisis revealed the need to incorporate macro-prudential regulation into the financial system.  Earlier this year, the British government decided to change the operating model, and on September 18, it solicited comments on this reform effort.

On January 26, 2012, the government published the Financial Services Bill, which introduced a new model of firm regulation to replace and strengthen the existing regulatory architecture.

The Bill introduced the creation of three new entities: the Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA). The FPC will be charged with regulating the financial system as a whole using macro-prudential prudential powers.  The PRA and FCA will regulate individual financial institutions, though each with different responsibilities.

To accomplish its macro mission, the Bill provides the FPC the power not only to recommend actions, but also to issue directions to the PRA and FCA using macro-prudential tools.  The Bill proposes specific macro-prudential tools to empower the FPC to address systemic risks in the financial system.

One tool is the ability to set the level of England’s counter-cyclical capital buffer (CCB) as part of the European framework of constrained discretion to be implemented under Basel III.  “It will be deployed… when excess aggregate credit growth is judged to be associated with a build-up of system-wide risk.”  The FPC will set the CCB quarterly, the goal being that the banking sector “build up capital during periods of over-exuberance” to withstand downturns.

The other tool is the ability to set minimum sectoral capital requirements. The government found that many instances of over-exuberance occur in specific sectors before spreading further. Consequently, the bill suggests allowing the FPC to set capital requirements in individual sectors will allow for a more targeted response.

The Bill also introduces a separation of powers between the PRA and FCA, one covering the prudential issues of banks, insurers and large investment firms (PRA) and one covering all conduct issues as well as the prudential issues of all other firms (FCA).  Large financial institutions thus will face dual regulation.  According to Martin Wheatley, Managing Director of FSA, the purpose of this separation between the regulation of prudential and conduct operations is to promote a more proactive and intrusive approach to regulation and place the consumer at the heart of concerns.

At this early stage, it is difficult to assess the full impact of the changes, but it is expected to increase the regulatory burden and its costs.  “Dual regulated firms” are likely to see a significant increase in management and compliance costs and might face inconsistent regulatory instructions from the separate regulatory teams. “Dual regulated firms” that are subject to an assessment during the remainder of 2012 can expect two visits from both regulatory agencies.  Considering the new consumer protection objective of the FCA, investment firms also have to keep a close eye on how their services or products could potentially affect final users.