Will changes in the way financial institutions are supervised and regulated prepare us for the next crisis?
At the mention of the UK’s Financial Services Authority (FSA), a vision of horses cantering off into the distance, accompanied by the sound of doors being bolted, is prompted in many people’s minds.
The FSA has spent much of this year conceding the failure of ‘light-touch’ regulation. The Turner Review, conducted by its chairman and published last spring, outlined fundamental changes believed necessary in the approach to regulating banks. The review covered banks’ capital, their liquidity, methods of accounting, ‘shadow banking’, levels of pay, the role of credit rating agencies, derivatives trading, cross-border banking and EU supervision and regulation.
It also proposed changes in international regulation.
New liquidity rules are already in place. Its supervision team has been beefed-up. The FSA, as it would see it, is getting tough; using recently hired technical experts, it now employs what it describes as “intense and intrusive” levels of supervision. A remuneration code will come into effect from the beginning of next year, but which will cover bonuses that the banks want to pay its staff for 2009. It will also interview senior executives in firms and their holding companies, essentially to assess whether they are up to the job.
A review of the mortgage market, designed to curb high-risk lending, is currently out for consultation. The scheme for compensating consumers will come under scrutiny next year.
And, on an international level, the FSA does not miss an opportunity to remind us that its proposals for European and global regulation form the basis for what governments are attempting to agree will prevent another crisis.
The job of convincing the public here that this is sufficient falls to Jon Pain, the FSA’s managing director of supervision. “We have on numerous occasions owned up to the FSA’s regulatory failures, particularly post- Northern Rock,” said Pain. “The regulatory philosophy pre-2007 was fundamentally different from what it is today. The approaches that we took were dictated by the market and the regulatory authorities at the time but, with hindsight and as things have changed, we recognise that some of them are no longer appropriate.” Pain assumed his new role during an internal shake-up of the FSA conducted during the summer. He has overall responsibility for regulating firms or groups whose business is with retail consumers, including banks, insurance companies and mortgage lenders. Pain, a former managing director of Cheltenham & Gloucester, will also oversee 17,000 smaller firms engaged in mortgage advice, insurance broking and investment advice. A past chairman of the Council of Mortgage Lenders and of the household committee for the Association of British Insurers, Pain sits on the FSA board.
The FSA has gone further than others in accepting it had fallen short, he said: “There were failures by the regulators, central banks and governments in not recognising some of the imbalances in the macro-prudential economy, which clearly had a lot of bearing on the crisis. We recognise that and our part in it; to be honest, I think that, in recognising the FSA’s failures, we have probably been more candid than most.” Pain now has a 1,200-strong team: “The FSA’s resources have grown 30-odd per cent since 2007 to just more than 3,000 staff in total. Our model is to use the direct supervision resources in my team, along with an array of dedicated risk specialists, actuaries and credit analysts in conjunction with those supervisory resources when we look at a firm. Post-Northern Rock, there has been a substantial increase in the amount of resources dedicated to individual firms of a particular size, particularly in the banking sector. We substantially increased the amount of resource that is dedicated to the larger banks in UK during that period.
“The increase has largely been in specialists drawn from the marketplace. They are not necessarily just supervisors; they are technical specialists on the whole spectrum of the firms that we regulate. That equips us with the specialists whom we need to look at firms and the risks that they pose both to our objectives and in respect of their own activities.
“It is evident from the financial crisis that the level of capital to support investment banking activities was not adequate. We have referred several times to the fact that there will be a substantive increase in capital to support investment banking activities. That in itself will drive a different appetite for such activities, because capital comes at a cost.
Firms will be far more wary about the risks to their balance sheet that are posed by the activities that they take on.
“A third issue is the governance and effectiveness of the boards of institutions. Post- Walker review, we expect a strengthening of capabilities around the board table. As part of our significant influence function regime, we have made it clear that we will interview— and sanction—members of boards of major financial institutions, particularly people who are in key posts, such as the chairman, senior independent non-executive director, chair of the audit committee and chair of the risk committee. Those interviews are not cosy chats around a coffee table but substantive reviews of the capability and competence of individuals to undertake their roles.
“Of course, they go hand in glove with the changes to the regulatory regime. I believe that, at a European and global level, there will be a higher level of capital required; redefinitions of the type of capital that banks need to provide; and different approaches to resolving problems with banks that get into difficulties, including the introduction of socalled living wills. Such new measures, which we are in the throes of implementing, will make the regulatory regime tighter and more capable of dealing with the outcomes of a crisis like the one that we have had to deal with over the past 18 months.” Bank failures remain a risk, however.
Resolution plans, so-called living wills, are being developed to deal with banks in danger of collapse in a way that minimises the fallout.
A consultation paper will be published next year and the FSA is undertaking work with pilot banks. But Pain said the work that had been done already to strengthen financial institutions should not be underestimated: “We operate and encourage the operation [on a global basis] of a series of supervisory colleges in which regulators share their insights into the operation of global institutions so that they can understand the impact that they have across those territories.
“The capital in those large institutions has already been strengthened, as you can see from recent market activity, and we have carried out extensive stress testing of those institutions to ensure that they have adequate capital, against our existing regime.
It is fair to say that, through our new regulatory approach, we expect to reduce the instance of failure. The resolution plans are designed to reduce the impact of any failure on the wider economy and on depositors.
“Over the past 18 months, we have also strengthened the depositor protection scheme.
There is still ongoing policy work in Europe about how that might be strengthened still further. Through the Financial Services Compensation Scheme, we have sought to put in place faster pay-out mechanisms for depositors as a further protection for depositors in those institutions.” But the biggest controversy that the FSA will face is in its handling of bankers’ bonuses. It has asked institutions to produce a remuneration policy statement that sets out how they will comply with the authority’s code. He denied that clamping down on bonuses would result in an exodus of key staff from the UK, saying that the code’s principles are likely to be adopted around the globe. While the public will want to see explicit caps on amounts, Pain said that the aim of the code was to ensure that the risk management within a firm was acceptable.
The FSA would intervene if bonuses put a firm’s capital position in jeopardy, but Pain said it was not “a regulator of the quantum of bonuses.” He added that the Royal Bank of Scotland had told the FSA that its chief executive Stephen Hester’s bonus for 2009, claimed to be £9.4m, would ultimately fall within the terms of the code.
Although Pain emphasised the “intrusive” approach to supervision of an institution and its senior executives, and pointed out that the FSA had taken action against individuals and boards, he stopped short of backing the idea that directors should be personally liable: “The consequences of such an approach would need to be thought about and analysed carefully. We would need to consider how having personal liability might play out in respect of people’s willingness to undertake to be directors of financial institutions.
“Over the past 12 months, our ability to gain people’s commitment to being nonexecutive directors of financial institutions has been severely tested. The pool of people who would want to take on those responsibilities or who are qualified to do so is not deep.
Our putting more impediments in that area might have unintended consequences for the calibre and breadth of financial institutions’ boards.”