The Past and Future of Financial Regulation in the UK

By Jonathan Halsey

17 June 2010


George Osborne’s Mansion House speech on 16th June tolls the bell for the Financial Services Authority.

He states: “The FSA became a narrow regulator, almost entirely focussed on rules based regulation.”

That is debatable. In my view the FSA followed an almost cyclical evolutionary series of changes.

The Past

It started in the nineties with the “three tiered” architectural metaphor, with the “overarching” ten Principles of its predecessor the Securities and Investments Board and their forty or so “core rules” below which lay the detailed and prescriptive conduct of business rules, simple capital requirements for investment firms, ombudsman and compensation schemes and specialist rules for collective investment schemes.

As time passed the FSA took on additional responsibilities: mortgages, the insurance sector and the listing authority.

During the first decade of the 21st century the FSA took over from the Bank of England the prudential supervision of banks and building societies. It is at this point that I think FSA bit off more than it could chew. Compliance Officers may recall ploughing through endless versions and revisions of prudential rulebooks, culminating in what is now the Prudential Sourcebooks, one for Banks, Building Societies and Investment Firms (BIPRU), one for Insurers (INSPRU), one for Mortgage and Home Finance Firms and Insurance Intermediaries (MIPRU) and one for UCITS Firms (UPRU), as well as the General Prudential Sourcebook for all of the above (GENPRU) and five interim sourcebooks, some provisions of which still apply.

This spaghetti alphabet of capital adequacy manuals was further complicated by the constantly evolving face of Brussels and the FSA’s noble spirited implementation of the Investment Services Directive, UCITS Directives 1, 2 and 3, the Capital Adequacy Directive and more recently MiFID into their Handbook.

Against this background FSA moved away from rules-based regulation towards “principles based” regulation, and in doing so perhaps implicitly acknowledged that the details had become just too complicated and that their raison d’etre was really to make sure that their four regulatory objectives were met as stated in section 2 of FSMA 2000:

1 market confidence;

2 public awareness;

3 the protection of consumers; and

4 the reduction of financial crime.

In a further refinement the term “outcomes based” regulation was added to the regulatory approach, the prime example being Treating Customers Fairly (TCF). Firms reacted in differing ways to this. Firms that act as agent for their customers were in a better position to comply with the TCF regime than those who, like banks, act as principal in relation to their customers.

While all of this was going on at Canary Wharf, a force twelve gale blew the financial services sector into its worst crisis in living memory. The FSA found itself high and dry and in the media firing line for allowing the Northern Rock debacle to occur.

As a line of defence, FSMA 2010 was enacted in April 2010, among other changes adding a fifth objective for the FSA, “financial stability”.

But it was too late; the tide had turned. The last year and a half has seen FSA develop into a different kind of animal from what it had been in its early years. Noticeable trends were:

1 To get very much tougher on firms and individuals, denying some individuals the opportunity to work in the industry. Fines levied in the first two and a half months of the FSA’s fiscal year 2010-2011 have amounted to three times the average annual fines of the three years 2006-2009.

2 To start hiring staff at an unprecedented rate at a time when their own future was in the balance. This is a move not unlike a “poison pill” approach adopted by some corporate takeover targets.

3 To increase vastly the number of “section 166”, or skilled persons reports, where a firm has, at its own expense, to contract an independent individual with appropriate expertise to review the firm’s records and procedures and then recommend remedial action.

These trends are consistent with FSA’s intention to change the perception of their being a reactive regulator into a proactive regulator. The word “proactive(ly)” appears ten times in the Annual Report 2009/10 and eight times in the Business Plan 2010/11.

Hector Sants, FSA’s CEO has said he wanted the FSA to become a “scary” regulator. This is also consistent with the above trends and illustrates the maxim that the best form of defence is offense.

The Future

Let us look at the future in terms of the five regulatory objectives:

George Osborne states that FSA “will cease to exist in its current form”. According to the Mansion House speech a new prudential regulator will be formed that will be a subsidiary of the Bank of England. This will effectively take objective no. 1 (market confidence) away from FSA.

Meanwhile a “Consumer Protection and Markets Authority” is to be established to regulate every firm providing financial services to consumers. This will roughly take away objectives 2 (public awareness) and 3 (protection of consumers) from the FSA.

A new Financial Policy Committee within the Bank of England will be given the power and responsibility to look at the “macro issues that may threaten economic and financial stability and take effective action in response.” This takes objective 5 (financial stability) away from FSA.

The last remaining objective - the reduction of financial crime – will be taken off FSA by the single agency to be created “to take on the work of tackling serious economic crime that is currently dispersed across a number of Government departments and agencies”.

This leaves the FSA with no regulatory objectives.

Naturally there will be a fairly lengthy transition period, around two years at a rough estimate. I do not think FSA staff should be too worried about their jobs as this is a reshuffle rather than an abolition.

Staff will no doubt be re-deployed into the new agencies and there is an element of continuity in the fact that Hector Sants will be heading up the new Bank of England unit.

A number of logistic exercises have to be addressed, not least concluding outstanding investigations and enforcement initiatives. Regulated firms can but hope that the new order will be an improvement and will foster a better level of trust not only for investors and customers but also between the regulators and the firms they regulate.

Another key consideration is the quality and competence of staff in the new agencies. FSA has been criticised in the past for judging businesses their staff are not competent to pass judgement on. The new Bank of England unit is all very well for banks but what about all the other myriad types of business under the somewhat vague “financial services” umbrella - IFAs, investment managers, derivatives traders, foreign exchange products, spreadbetting, UCITS funds, non-UCITS regulated schemes, unregulated onshore and offshore schemes, life insurance, non-life insurance, mortgage selling – the list goes on and on.

Finally, what are we going to do with the Financial Services and Markets Acts? I presume they will be repealed and replaced by something more straightforward that takes into account European Directives and builds in flexibility in anticipation of a regularly mutating legal environment. Oh – and the FSA Handbook. Many Compliance Officers will be delighted to kiss goodbye to that many-headed 8000-page monster! For those of us who remember the original IMRO Rulebook, that would be a good replacement....