Bank Structure and Regulation in the UK - Modern Banking

Background

The UK’s banking system falls into the ‘‘restricted universal’’ category, because banks are discouraged from owning commercial concerns. It is made up of: commercial banks consisting of the ‘‘big four’’ UK banks, HSBC (Hong Kong & Shanghai Banking Corporation), the Royal Bank of Scotland group, HBOS (Halifax-Bank of Scotland) and Barclays, with tier 1 capital in 2002 ranging from $35 billion (HSBC) to $18 billion (Barclays), and the Group, together with about a dozen or so other major banks including Lloyds-TSB ($13.3 billion), Abbey National, Standard Chartered and Alliance and Leicester ($2.5 billion). The big four, and some of the other banks, engage in retail, wholesale and investment banking, and some have insurance subsidiaries. By the turn of the century, many of the traditional English merchant banks had been bought by foreign concerns, beginning with Deutsche’s purchase of Morgan Grenfell bank in 1988. Kleinwort-Benson was bought by Dresdner, and War burgs by the Union Bank of Switzerland. Barings, having collapsed in 1995, was bought by ING, but later closed.

Some building societies converted to banks following the Building Societies Act, 1986. Effective January 1987, the Act allowed building societies to convert to bank plc status, to be supervised by the Bank of England, and protected from hostile takeover for five years. Most of the top ten (by asset size) building societies in 1986 had, by the new century, given up their mutual status. The early conversions were Abbey National (1989), Bristol and West, Cheltenham and Gloucester (1992; a subsidiary of Lloyds-TSB). Building societies that converted between 1995–7 were the Halifax (after a merger with Leeds BS), Alliance & Leicester, Northern Rock and the Woolwich (taken over by Barclays in 2000). Birmingham Midshires was purchased by the Halifax in 1999; Bradford&Bingley converted in 2000.

Building societies have a long history in British retail finance. Members of a society paid subscriptions, and once there was enough funding, a selection procedure determined the member who would receive funds for house purchase or building. The early societies were attached to licensed premises (e.g. the Golden Cross Inn in Birmingham, 1775) and were wound up after all members had paid for their houses. The first legislation on them was passed in 1836. In 1845, permanent societies began to form, such as the Chesham Building Society. Members kept a share (deposit) account at a society and could, after a period of time, expect to be granted a mortgage. Over time, depositors and mortgagees were not necessarily from the same group.

As mutual organisations, every customer (depositor or borrower) has a share in the society, with the right to vote on key managerial changes. Each vote carries the same weight, independent of the size of the deposit mortgage or loan.

In 1984, an informal but effective cartel linking the building societies dissolved after Abbey National broke ranks. By this time, many of the larger societies viewed the ‘‘big four’’ and other banks as their main competitors. The Building Societies Act (1986) took effect in January 1987, and allowed building societies to offer a full range of retail banking services typical of a bank. The Act specified the financial activities a building society could undertake, namely:

  1. Offering a money transmission service through cheque books and credit cards.
  2. Personal loans, unsecured.
  3. Foreign currency exchange.
  4. Investment management and advice.
  5. Stock broking.
  6. Provision and underwriting of insurance.
  7. Expansion into other EU states.
  8. Real estate services.

However, there were important restrictions: 90% of a building society’s assets had to be residential mortgages, and wholesale money plus deposits could not exceed 20% of liabilities, subsequently raised to 40%, then 50%.

The 1986 Act also gave these organisations the option of converting to bank status, and as a result, the number of building societies fell dramatically as table below shows. The conversions between 1995 and 1997 resulted in two-thirds of the assets being transferred out of the sector.

Number of UK Building Societies,1900–2002

Number of UK Building Societies,1900–2002

A Selection of UK Building Societies, 2003–2004

A Selection of UK Building Societies, 2003–2004

A revised Building Societies Act was passed in 1997 to make mutual status a more attractive option. It relaxes the prescriptive 1986 Act by allowing mutuals to undertake all forms of banking unless explicitly prohibited. In addition, any converted building society which attempts a hostile takeover of another building society loses its own five-year protection from takeover. Nonetheless, important restrictions continued to be placed on their assets and liabilities. At least 75% of their assets must be secured by residential property, and 50% of funding has to come from shareholder deposits.

There is considerable variation in the size of the remaining building societies, as Table above shows. In 2003, the building society sector had 18% of the outstanding household mortgage market and 18% of personal deposits.

Building societies had been regulated by an independent Building Societies Commission (BSC). Under the Financial Services and Markets Act (2000), the BSC was subsumed by the Financial Services Authority (FSA – see below), and large parts of the previous legislation relating to building societies became redundant, though similar rules have been imposed by the FSA.

An increasing number of non-bank firms offer some retail banking services. Good examples are the supermarkets, Sainsbury, Tesco and Safeway. They offer basic deposit and loan facilities. Virgin plc is one of several firms that offers a product whereby savings and mortgages (a condition of holding the account) are operated as one account. All these firms either operate as a separate subsidiary, subject to regulation by the FSA, or use an established bank to offer these services (e.g. as a joint venture), such as the Royal Bank of Scotland, HBOS and Abbey National. For this reason, it is debatable whether these firms are genuine non-banks. Insurance firms such as the Prudential and Scottish Widows offer a retail banking service without branches, relying on postal, telephone and internet accounts to deliver their services.

Finance Houses or non-bank credit institutions account for a tiny proportion of UK funding. They borrow from banks, etc., provide instalment credit to the personal and commercial sectors, and are involved in leasing and factoring (purchase all or some of the debts owed to a company – the price is below the book value of the debt (assets)).

Friendly Societies were first defined in law in 1793. As mutual organisations, members make contributions to a fund which in turn can provide relief for a member in times of hardship – e.g. sickness, old age, unemployment. Some provide a form of insurance, and often provide disproportionate amounts (in terms of the amounts paid in) to those who encounter hardship. Since the 2000 Financial Services and Markets Act, they have been regulated by the FSA, though many of the rules have been carried over from the 1992 Friendly Societies Act. In 2001, 104 societies were authorised to engage in new business, and another 247 not authorised because of declining membership or their very small size.

There are also investment institutions such as pension funds, insurance firms, unit trusts, investment trusts, and so on. These are not banks in any sense of the term, but investment tools, often managed or offered by banks.

Table below provides a snapshot of the UK financial structure in 2002. Table below reports the key ratios for the top 5 banks in the UK.

UK Banking Structure 2002

UK Banking Structure 2002

Top UK Banks (by tier 1 capital) in 2003

Top UK Banks (by tier 1 capital) in 2003

UK Financial Reforms in the late 20th Century

In 1986, the ‘‘City’’8 of London underwent ‘‘Big Bang’’, or a series of financial reforms to change the structure of the financial sector and encourage greater competition. The reforms gave UK banks and other financial firms opportunities to expand into new areas. At the same time, London wanted to maintain its reputation for quality, and new financial regulations were introduced, designed to ensure continued financial stability within a more competitive environment. Just over a decade later, banks and other financial sectors were subject to major changes in regulation again. One objective of this is to explore how and why regulation changed in such a dramatic fashion.

The Financial Services Act (1986) was the culmination of a number of radical reforms of the UK financial system, known as ‘‘Big Bang’’. The government put pressure on the London Stock Exchange to get rid of cartel-like rules. The first reform was in 1982 when ownership of stock exchange firms by non-members was raised from 10% to 29.9%. By 1986, new firms could trade on the stock exchange without buying into member firms.

Dual capacity dealing was introduced, eliminating the distinction between ‘‘brokers’’ and ‘‘jobbers’’. Stock exchange members became ‘‘market makers’’, that is, making markets in a stock and acting as brokers: buying and selling shares from the public. Minimum commissions were also abolished.

These reforms made it attractive for banks to enter the stock broking business, and most of the major banks (both commercial and merchant) purchased broking and jobbing firms or opted for organic growth in this area. Around the same time, the traditional merchant banks became, effectively, investment banks by expanding into other areas, such as trading:

equities, fixed income [bonds] and later, proprietary trading, asset management, global custody and consultancy.

Some commercial banks purchased investment banks (e.g. the Trustee Savings Bank bought Hill Samuel) while others, having purchased firms to offer stock broking services, used them as a base to expand into other areas of investment banking. The only exception was Lloyds Bank, which opted to focus largely on retail banking, with some commercial banking. There were other important reforms of the UK financial system that affected banking and the financial structure.

  • Competition and Credit Control (1972): terminated the banking cartel, among other changes. The cartel was an agreement among banks that the deposit rate would be 2% below base rate; personal loan rates would be 1–3% above base, and no interest was paid on current accounts.
  • The Special Supplementary Deposit Scheme: if interest earning deposits grew beyond a certain limit, banks were subject to an increasing reserve ratio (a tax on banks). The objective was to reduce deposit rates on accounts, which in turn would help to keep down building society mortgage rates and government debt servicing charges.
  • End of exchange controls on sterling (1979).
  • The collapse of an informal but effective building society interest rate cartel (1984).
  • The Building Societies Act (1979; amended 1987).
  • The Banking Act (1979; amended 1987).
  • Financial Services Act (1986).
  • The 1998 Banking Act.
  • The Financial Services and Markets Act (2000).

The legislation on Building Societies has already been discussed, and the last four acts listed are discussed below, to illustrate how the regulation of UK financial institutions evolved over a relatively short period of time.

The Financial Services Act, 1986

The main objective of this Act was the protection of investors in the ‘‘Big Bang’’ era.

Self-regulation was introduced for all financial firms. A two-tier system, the lower tier consisted of SROs or self-regulatory organisations, which would regulate different functions.

Originally, there were six SROs, each responsible for the regulation of futures dealers, securities dealers, investment managers, personal investment, life insurance and unit trusts. The number was later reduced to three: the Securities and Futures Association (SFA), IMRO (the Investment Managers Regulatory Organisation) and PIA (the Personal Investment Authority). These SROs reported to the Securities and Investment Board (SIB), the upper tier, which was an umbrella organisation with statutory powers.

Chart below shows the organisational structure under this regulatory regime. Together, they were responsible for ensuring the proper conduct of business by the investment community.

The Act required all firms belonging to a SRO to adhere to a number of rules. Managers had to meet ‘‘fit and proper’’ standards. Depending on the nature of the business, adequate capital was to be set aside. General conduct of business rules set by the relevant SRO had to be met. All members contributed to a compensation scheme for investors should a member go bankrupt and/or default on their obligations. Claims up to £30 000 were met in full, and for sums between £30 000 and £50 000, 90% of losses were reimbursed, for a maximum payout of £48 000.

In addition to the SROs, there were three prudential regulators, the Bank of England for banks, the Building Societies Commission for building societies, and the Department of Trade and Industry for insurance regulation. The self-regulating bodies were thought to be the best judges of the standards and rules of conduct for their members because they have more information and knowledge about the operations of the financial business in question (e.g. insurance companies, stock broking, etc.). State regulators will always be less well informed. It was also argued that public regulators can develop a close relationship with the firms they regulate, causing laxity in their enforcement of regulations, and in some instances, a vested interest in trying to protect insolvent firms from closure, known as regulatory forbearance (or regulatory capture). The SRO system would prevent this problem from arising. However, though there is substantial evidence of this problem occurring among

UK Self-Regulatory, Functional regulation (based on the Financial Services Act, 1986).

UK Self-Regulatory, Functional regulation (based on the Financial Services Act, 1986).

state regulators (for example, US regulators in the 1980s), there is no reason why it may not occur under self-regulation. Cynics often argue that SROs and the firms they regulate are more like a club.

There are also arguments which favour regulation by government bodies. Though a SRO may have better information with which to draw up an impressive set of regulations, their enforcement powers are minimal, though the British system granted statutory powers to the SIB. Public regulators can resolve the information problem by hiring individuals with extensive experience in the relevant financial business, though normally salaries in the public sector are lower, making it difficult to attract the best expertise. Another potential problem is that self-regulation might encourage collusive behaviour among firms because of the close connections between the practitioners who regulate, and the regulated. The increase in the number of financial conglomerates is also cited as a factor which favours state regulation. Under self-regulation conglomerates face costly compliance – having to satisfy the requirements of multiple regulators rather than just one single body. But this point is more an argument in favour of a single, but not necessarily state, regulator.

The 1979 UK Banking Act (Amended, 1987)

Prior to this Act there was no specific banking law in the UK. Prompted by the secondary banking crisis in 1972, the Bank of England, for the first time in its history, was assigned formal responsibility for the prudential regulation of UK banks. The Bank of England was nationalised in 1946, and had been responsible for price and general financial stability, answering to Her Majesty’s (HM) Treasury. The 1979 Act covered clearing and merchant banks, finance and discount houses, and foreign banks. The Bank of England decided on whether a firm was given bank status.11 To qualify for bank status, the firm had to offer facilities for current and deposit accounts, overdraft and loan facilities to corporate/retail customers, and at least one of: foreign exchange facilities, foreign trade documentation and finance (through the issue of bills of exchange and promissory notes), investment management services, or a specialised banking product. Also, the Bank of England had to be satisfied that the ‘‘bank’’ had an excellent reputation in the financial community, the affairs of the bank were conducted with integrity and prudence, the bank could manage its financial affairs, and ‘‘fit and proper’’ criteria were applied to all directors /controllers /managers. These conditions ensured an ongoing supervisory function for the Bank, because it could revoke bank status at any time.

A Depositors Protection Fund was established under the 1979 Banking Act – all recognised banks contribute to the fund. In line with EU policy the current protection is: compensation for up to 90% of any one deposit, for deposits up to a maximum of £35 000 or the equivalent in euros. The 10% co-insurance means no individual depositor is ever repaid the full amount of the deposit held in a bank that fails – the maximum payout is £31 500. The reason for co-insurance is to give each depositor an incentive for monitoring the health of his/her bank.

The key 1987 amendments to the Banking Act included the following.

  1. A clause ‘‘encouraging’’ auditors to warn supervisors of bank fraud, with auditors being given greater access to official information.
  2. Exposure rules were changed – the Bank was to be informed if the exposure of any single borrower exceeded 10% of the bank’s capital, and was to be consulted if a loan to a single borrower exceeded 25% of its capital.
  3. Any investors with more than 5% of a bank’s shares must declare themselves.
  4. The purchase of more than 15% of a UK bank by a foreign bank may be blocked by the authorities.
  5. A Board of Bank Supervision was established, the result of a recommendation of a committee set up after the rescue of the failing Johnson Matthey Bankers by a Bank of England led lifeboat. The new Board assists the Bank of England in its bank supervisory role. It is chaired by the Bank’s Governor but includes a number of independent members with a background in commercial banking.

There was no single disaster or scandal which prompted demands for a reform of the system, though the closure of BCCI (1991) and the collapse of Barings (1995) raised questions about the supervisory abilities of the Bank of England. Nor was there evidence of collusion between the Bank of England and regulated banks. However, practitioners and regulators alike recognised that the system was increasingly cumbersome, and ill-fitted to financial firms which had to answer to more than one of the SROs. After 1986, banks expanded into securities, stock broking, insurance and a host of other financial activities. A major bank could find itself having to report to the Bank of England, comply with the rules set by different SROs, and answer to other prudential regulators. Lead regulators were designated for certain large banks. For example, the Bank of England had sole responsibility for the supervision of Barings Bank because Barings had solo consolidation status. The parent bank and its subsidiary, Barings Securities, produced one set of capital and exposure figures. With greater expertise in the securities area, the SFA might have demanded explicit changes in the Singapore operations had they been regulating Barings Securities.

Thus, it seems a number of factors were responsible for another major shake-up of the British financial sector. In just over a decade, the UK financial sector was the target of more regulatory change than it had experienced over the entire century. In May 1997 the Chancellor of the Exchequer announced that the Bank of England was to be ‘‘independent’’ of the Treasury. A Monetary Policy Committee, chaired by the Governor of the Bank, would meet monthly and announce what the central bank interest rate is to be, with a view to meeting inflation targets set by the government. Less than a fortnight later an end to self-regulation by function was announced. Responsibility for all aspects of financial regulation (e.g. prudential regulation and conduct of business) was given to a single state regulator, the Financial Services Authority or FSA. The role of the FSA is discussed below.

The 1998 Banking Act transferred the Bank of England’s supervisory and related powers to the newly created Financial Services Authority. Though the Bank of England’s formal role as prudential regulator was short-lived, it continues to share responsibility for financial stability, with the FSA and HM Treasury under a Memorandum of Understanding (see below). As a consequence of the Act, the FSA took over responsibility for the authorisation, and, where applicable, the prudential regulation of all financial institutions, and the supervision of clearing and settlements and financial markets.

The 1998 Act also transfers responsibility for the Deposit Protection Board, which administers the Deposit Protection Fund, to the FSA. The Deputy Governor of the Bank of England responsible for financial stability is a member of the board but the FSA Chairman chairs it.

The membership of the Board of Banking Supervision was changed by the 1998 Banking Act. It now consists of six independent members (with no executive responsibility in the FSA) and two ex officio members from the FSA. The independent members decide who among them will act as Chair.

The Financial Services and Markets Act (FSM Act) was passed on 12 June 2000, after a record 2000 amendments, and established the Financial Services Authority as the sole regulator of all UK financial institutions. The FSA assumed its full powers by November 2001. It is bound, by statute, to:

  • Maintain confidence in the UK financial system.
  • Educate the public – with special reference to the risks associated with different forms of investing.
  • Protect consumers but encourage them to take responsibility for their own financial decisions.
  • Reduce financial crime.

The FSA is also obliged to be cost effective. It is required to use cost benefit analysis to demonstrate that the introduction of a regulation will yield benefits that outweigh any costs (e.g. compliance costs for banks). The government has instructed the FSA to adopt some recommendations made by the Cruickshank (2000) bank review team. They include the introduction of CAT(charges, easy access, reasonable terms) standards for credit cards. The FSA is also reviewing the Banking Code, which sets the standards of service for personal banking. The banks’ adherence to the code is thought to be weak. It is likely to be extended to include small business.

Cruickshank recommended the FSA be given an additional statutory objective of minimising any anti-competitive effects in markets arising from FSA regulations. Instead of imposing a fifth statutory obligation, the Financial Services and Markets Act emphasised the need to minimise any such effects, which will be monitored by the Office of Fair Trading, the Competition Commission and the Treasury. The need for the FSA to encourage competition among the firms it regulates was also noted in the Act, and it was given responsibility for developing a set of disclosure of information rules for mortgage lenders. In May 2001, the FSA employed just over 2000, with regulatory responsibility for about 660 banks, 7500 investment firms, insurance firms with annual premiums of £48 billion, and over 40 000 investment advisors. The business generated by the firms regulated by the FSA accounts for just under 6% of UK GDP. The FSA is a private company, funded by levies paid by the financial firms it supervises.

The regulators merged to make up the FSA included the following.

  • The Self-Regulatory Organisations: Securities and Investment Board, Securities and Futures Association, Personal Investment Authority and Investment Management Regulatory Organisation.
  • A Single Financial Regulator in the UK (based on the Financial Services and Market Act, 2000).

    A Single Financial Regulator in the UK (based on the Financial Services and Market Act, 2000)

  • The banking supervision division of the Bank of England.
  • The Register of Friendly Societies, Friendly Societies Commission.

In addition, in 2000, the FSA was given responsibility for:

  • The Building Societies Commission.
  • The Insurance Directorate at the Department of Trade and Industry.
  • The UK Listing Authority, which regulates solicitors, accountants and actuaries, if their businesses offer financial services to a substantial degree.
  • Credit unions.

The FSA reduced the 14 rule books associated with the different regulators to one FSA Handbook. The Handbook is more than several feet thick, and therefore, difficult to grasp! However, it is smaller than the sum of the 14 books it replaced. There are four prudential regulation regimes: banks, building societies, friendly societies and insurance. To date, FSA rules focus on three areas: to ensure firms have the right systems and controls, to require management, especially senior management, to be responsible for complying with FSA rules, and to make staff aware of the FSA’s view of what constitutes desirable behaviour. Tables of the FSA Discussion Paper (2002) illustrate what the financial firms (e.g. banks, building societies, insurance) report in relation to financial information, systems and controls, and conduct of business. The large differences and discrepancies identified by the FSA is one of the reasons why it favours adopting a risk based approach to regulation (see below).

An inevitable consequence of a rule based regulatory system is the use of lawyers hired by firms not only to ensure compliance but also to look for any loopholes that might benefit the firm, which will lead to more rules. Their presence at meetings will discourage the free flow of information. Firms are reluctant to reveal information about their activities (especially those which are problematic) for fear of having new rules imposed on them. This problem is potentially very serious for contagion inclined sectors, such as commercial and retail banking.

The success of the ‘‘City’’ (London’s financial district) has been partly due to getting regulation correctly balanced, that is, being adequately regulated but at the same time, allowing various firms to innovate, to maintain a competitive edge over other financial centres. However, a rule based system discourages innovation. When new ideas have been put to the FSA for approval, firms have to answer extensive lists of questions, and, it is reported, some are confronting long delays before a decision is taken.

Finally, though the FSA is considered a ‘‘one stop’’ integrated regulator of financial firms, there are other regulators. For example, there are numerous ombudsmen, the Office of Fair Trading, consumers groups and, in the case of non-investment markets such as foreign exchange dealing, firms still have to comply with codes laid down by the Bank of England.

Prudential Regulation by the FSA

The FSA’s Handbook of Rules and Guidance consists of very long volumes, which cannot be covered in any detail here.

Even though the FSA deals with the prudential concerns of all financial firms, the emphasis here is on how it regulates banks. The interim sourcebook for banks and building societies includes many of the regulations derived from the Banking Act, and its amendments. However, readers are reminded that regulation of banks (and other financial firms) is increasingly being driven by the European Union’s directives and the Basel agreements and accords. Thus, rules governing capital and liquidity adequacy are largely determined by the EU and Basel agreements. Also, as a member of the European Union, the UK is committed to adopting the IASB accounting standards by 2005 for listed companies in the first instance. However, there is nothing to stop the FSA from imposing additional rules and regulations. One of the most important is the risk based approach to regulation.

The FSA’s Risk Based Approach to Regulation: RTO

As supervisor for all financial institutions, the FSA is trying to move away from specific rules for each of the different types of financial institution. Of course, it is not possible to introduce a single system of supervision, because the prudential concerns vary depending on the institution. For banks, the issue is contagion caused by a problematic bank or banks which causes liquidity to dry up, leading, in time, to insolvency. For insurance firms, customers worried about the value of their policies will try to cash them in early. Keeping the financial markets liquid is critical to the success of the securities sector. So while some aspects of the regulation are unique (hence the different sourcebooks), the FSA is keen to introduce rules which apply across all financial institutions. They have done this by introducing a risk based, as opposed to competition based, approach to regulation. The competition based approach has been adopted by the telecommunications and utilities sectors in the UK. After these industries were privatised, the decision was taken to place competition and good value for customers ahead of security of service supply (electricity, gas, water, etc.). This was achieved by creating several suppliers (e.g. gas, electricity, telephones) and encouraging competition. Firms are allowed to increase prices by the rate of inflation less some predetermined percentage, announced by the regulator.

The idea was to have the real price of these services fall over time.

The FSA opted for the risk based route, also known as RTO (risk to our objectives), indicating that they consider the financial sector to be of such importance to the economy that risk management must take priority. According to the FSA, such an approach is necessary because of its statutory responsibility for maintaining the financial sector, including minimising any adverse effects of competition between FSA regulated firms. The RTO approach involves computing a score for each firm supervised by the FSA. The score will show the probability of the firm having an impact on the ability of the FSA to meet its four statutory objectives outlined earlier. The score is obtained from a simple equation:

IMPACT SCORE = [Impact of the problem] × [Probability of the problem arising]

A firm’s score will determine how closely the FSA monitors it. If the impact score is low, then the firm is likely to be monitored through the completion of various checklist forms, while a high impact firm will require continuous meetings and regular visits made by the FSA.

Each firm is scored varying from A(very high risk) to D (low risk). The risk is not confined to the risk of financial instability, but any risks that might prevent the FSA from meeting its statutory obligations. So for example, firms might be designated high risk because:

  • As deposit takers, the firm could be the target of panics about the quality of the bank.
  • The firm conducts a business that could prevent the FSA from protecting consumer interests. For example, for the average consumer, valuation is difficult for products such as unit trusts, insurance and endowment mortgages.
  • The activities of a firm might encourage a financial crime, such as money laundering and/or insider trading. After ‘‘9/11’’, banks, bureau de change outlets, and other financial firms have been asked to tighten procedures to guard against money laundering. In 2003, Northern Rock was fined £1.25 million by the Financial Services Authority for failing to comply with the rules on money laundering set out in the FSA’s Sourcebook.

Note the emphasis on high impact financial firms in terms of how their actions affect the FSA’s ability to fulfil its statutory obligations; NOT, say, systemic risk. However, any threats to systemic risk are dealt with through the special rules applied to different types of firms such as banks, building societies, insurance firms, and so on. For example, the special approach adopted for the supervision of financial conglomerates was discussed. In addition, the FSA has a memorandum of understanding with the Bank of England and HM Treasury – see below.

The FSA anticipates that 85% of the firms supervised by it will be given the lowest risk rating, D. High impact groups will include: major banks, the large insurance firms, the big broker-dealers, stock exchanges and big networks of independent financial advisors. When the Bank of England was responsible for the supervision of banks, it was well known for employing a consensusapproach to bank supervision. There was no formal examination of a bank’s books by the supervisor, and ratios (with the exception of the Basel minimum and European directives) were negotiated rather than imposed. The BE relied on guidelines rather than strict rules. This approach had been eroding over time with the large increase in the number of banks.

In addition to computing an impact score, the FSA makes a number of specific demands on banks.

  • The FSA sets the criteria for licensing banks and can reject an application or withdraw an existing licence.
  • ‘‘Fit and proper’’ criteria are applied to key positions. The FSA must be notified if any person plans to take (or increase) control of a bank, and can refuse to sanction the change.
  • In addition to the Basel risk assets ratios and requirements, the FSA sets an individual capital ratio for each bank, based on its risk profile. Capital requirements must be satisfied on a consolidated and solo basis. The risks of each bank are assessed by a firm-specific model.
  • The FSA is in the process of developing a new approach to monitor banks’ liquidity which is closely aligned to the systems used by the banks themselves.
  • As part of the EU, UK banks must comply with the EU’s large exposures directive.
  • There are no explicit rules on credit/investment policies, which is considered the domain for each bank’s management group. However, the FSA must be satisfied with banks’ procedures for taking, monitoring and controlling risk.
  • Banks can be asked to supply regular information on asset quality if there is a reason to be concerned about them, but there is no established system for supplying data on classified or non-performing loans.
  • Each bank must be externally audited, and have a system for independent internal audits.
  • The FSA or external auditors can examine the internal audits, and external auditors must inform the FSA of any concerns they might have. The FSA has the power to dismiss external auditors.

  • On-site examinations are reserved for high impact firms. FSA supervisor staff may be supported by its risk management specialists and/or it may call in ‘‘skilled persons’’ (normally from an independent accounting firm) to help with any inspection. As has been noted, high impact banks may expect regular visits and frequent contact with senior management and directors. By contrast, low impact banks will be supervised off-site through monitoring of key ratios unless some event or revelation of excessive risk taking prompts site visits/contact with bank management. The FSA defends this approach on the grounds that this group of banks account for only 0.02% of deposit liabilities.
  • Banks will face restrictions on overseas activities if the FSA is not satisfied with a bank’s risk management system in one of its foreign business units.
  • Banks are required to appoint a money laundering reporting officer who is approved by the FSA.

The Bank of England and Financial Stability

A central bank will always be involved in the preservation of financial stability because it will act as the lender of last resort, and/or play a key role in any lifeboat rescue, injecting any liquidity needed to stabilise markets. Financial stability is also a statutory obligation of the FSA, hence a Memorandum of Understanding was deemed essential. The MOU (Appendix 5 of the 1998 Bank of England Act) is between the Treasury, the FSA and the Bank of England. These organisations are jointly responsible for financial stability, including the reduction of systemic risk and undertaking official operations to prevent contagion. A tripartite standing committee was established, consisting of the respective heads of the three organisations, and chaired by the Chancellor. Though their deputies meet on a monthly basis, additional meetings take place in the event of any problem (e.g. a threatened bank failure) which could exacerbate systemic risk.

Under the MOU, an information sharing system has been put in place to ensure the FSA fulfils its obligation to supply the Bank with all the information needed to allow the Bank to meet is responsibilities in this area. In a recent IMF report (2003), the MOU is praised for its information sharing and clear line of responsibilities for each player. However, the report recommended that the FSA require banks to submit data (regularly) on classified /non-performing loans, pay greater attention to the supervision of market risk, improve the supervision of low impact firms, and address the issue of the potential for conflict of interest because it has to meet four statutory objectives.

A Single National Regulator?

There is a wide variety of regulatory systems around the world. In addition to the UK, Sweden, Denmark, Norway, Germany, Greece and Austria have single regulators for all financial firms. Canada has combined the supervision of financial and insurance firms (Office of the Superintendent of Financial Institutions) but securities firms are regulated by the provinces. Australia employs a ‘‘twin peaks’’ model, where the Australian Prudential Regulation Authority is separate from the central bank but conduct of business is the responsibility of the Australian Securities and Investment Commission. In Italy, the Banca d’Italia is responsible for prudential regulation and financial stability for banks and securities houses, while another body (CONSOB) deals with conduct of business issues. The Netherlands adopted a similar approach in 2002, but cross-sector activities are jointly regulated by the central bank and the insurance supervisor. In Japan, after recent reforms, the central bank shares bank supervision with the new regulator (since 2001), the Financial Services Authority.

In the United States, numerous bodies, both state and national, but including the central bank (the ‘‘Fed’’), are responsible for prudential regulation with separate agencies regulating securities and insurance firms. Multiple regulation is regarded as an important means of guarding against collusion within the financial sector. However, some aspects of ‘‘self regulation’’ have come under fire. The banks are members of the NYSE and NASD – both groups have been criticised for failing to spot the problem.

The UK introduced a single regulator relatively recently, as have other countries, though the UK has gone further in terms of the different types of financial firms the FSA supervises, and the wide range of objectives it must fulfil. This prompts the question of which regulatory model, if any, is superior. There are two issues. The first is the extent to which the central bank should be involved in the regulation of banks. The debate on the role of a central bank was aired. The second issue to be discussed here is whether a single body should be given responsibility for regulation of the financial sector. First, as was noted earlier, the growth of financial conglomerates favours a single regulator, because functional regulation is not only costly for conglomerates but may leave gaps. Functional supervision is also less effective as product boundaries become less well defined: securitisation and the growth of derivatives means risks can be unbundled and traded, weakening the distinction between equity, debt and loans, and the firms which supply them. Subjecting firms to a system of functional regulation could create difficulties. In the UK prior to the creation of the FSA, a lead regulator was often assigned to the financial firms engaging in multiple financial activities, but this procedure did not prevent regulatory failures such as the mis-selling of pensions, the Maxwell theft of pension funds, and a spectacular case of fraud at Barings. A single authority may be better at spotting potential difficulties at an earlier stage, and the adoption of a risk based scoring system should contribute towards integrated supervision.

However, there is a danger that supervision will continue along functional lines when there is a single regulator employing about 2000.

The main case for a single regulator is that greater efficiency is achieved because of economies of scale and scope. These include:

  • A single system of reporting for all firms. On the other hand, the data reported vary according to activities a given firm engages in. For example, the statistics for a bank are quite different from those of a stock broking firm.
  • Financial firms only need answer to a single regulator, which allows for a more effective system of communication, cooperation and coordination. This should mean the regulator can promote a public understanding of the financial services sector. In the UK, it is one of the FSA’s statutory obligations.
  • A single point of contact for regulated firms and consumers.
  • A common approach can be adopted for issues which affect all firms; an example is the FSA’s risk based approach.
  • More efficient resource allocation is also achieved if the single regulator can pool resources for the regulation of firms and activities. The risk points system developed by the FSA is one example but there are also many instances where separate rules must be developed for specific sectors. In the case of the FSA, this point is illustrated by the numerous, lengthy sourcebooks that have been produced for each major financial sector.
  • The FSA has developed a single framework for authorisation, supervision and investigation/ discipline, training and competence, consumer relations and central services.
  • However, it is too early to judge whether the obvious advantages from such a framework will be realised.

  • A single regulator is more likely to be able to recruit from the pool of experts, who, for example, are able to assess market risk models and other bank systems.

Bannock (2002) argues three types of costs must be included to obtain an accurate measure of the cost of regulation. These are:

  • Direct administration costs incurred by the FSA;
  • Compliance costs borne by different parts of the financial sector; and
  • Deadweight losses arising from market distortions created by regulation.

For example, the higher cost of regulatory compliance by independent advisors increases the cost of advice, which makes it uneconomic for them to assist the lower income groups, which may have the most to gain from such advice. There is also the potential for welfare gains (not mentioned by Bannock) if more financial firms are attracted to the UK because of the perception that the regulatory regime improves market quality and reputation. It is very difficult to measure deadweight losses (or gains). Excluding deadweight gains/losses, Bannock estimates the cost of UK regulation is £200 million (the FSA budget, 2001–2) plus £800 million in compliance costs, or in excess of £1 billion. These figures are at odds with those cited below, and disputed by Sykes (2002).

However, costs will be incurred by any type of regulation, and the challenge of the FSA/single regulator is to minimise the costs. The FSA must eliminate areas of overlap which existed under functional regulation with its multiple regulators. One of the FSA’s statutory obligations is to be cost effective. The FSA’s budget for 1999/2000 was lower in real terms than the sum of all the regulatory bodies that existed in the previous two years. Its actual budget for 1999/2000 was £154.5 million, which rose to £164 million in 2001/2, an annual increase which is well below the rate of inflation. The budget is lower than Canada’s Office of the Superintendent of Financial Institutions, and less than 10% of US regulatory costs. Certainly, in these early years, it appears to be cost effective. Costs are met by fees charged to the supervised firms: determined by the size of the business and the number of financial activities in which it is engaged – the more diversified the firm, the higher the fees.

Under multiple regulation, inconsistencies are more likely to arise, and a single regulator can ensure any differences reflect the unique features of a given financial sector. For example, retail banks or credit institutions face different types of liquidity risk, and the single regulator needs to ensure that more liquidity resources are allocated to the retail bank rather than being spread through the entire organisation.

There are a number of arguments against a single regulator. First, as a government agency, it lacks the expertise found in a system of self-regulation, where practitioners run the regulatory body. Government salaries tend to be low, making it difficult to attract experts from financial firms. One way to counter this problem is to establish a body similar to the Board of Banking Supervision, which has a large number of independent practitioners. The FSA could set up the equivalent in other areas such as securities and insurance.

Anticipating concern about accountability, the Financial Services and Markets Act has built in certain procedures to deal with this issue. The FSA Chairman and board members appointments are controlled by the Treasury, and the majority of its board members are non-executive. It is required to submit an annual report to Parliament on the extent to which it has met its objectives, and public meetings must be held to discuss the report.

Consumer and practitioner bodies can examine the FSA’s performance, and any firm affected by FSA decisions (e.g. sanctions, excessively onerous regulations) can appeal to an independent tribunal.

Multi-function firms have expressed concern at the cost of building up new systems to meet new rules of compliance under the FSA. In the short run, these costs offset the gains from having a single regulator, but only in the short run, as firms adjust to the new regulatory regime. Smaller firms may have a more legitimate concern because for the first time, they are having to employ compliance officers full-time, which was not necessary in the past. Another issue the FSA has to confront is the danger of imposing too many rules to ensure equitable treatment of different firms it supervises. As a counter to this problem, the FSA must employ cost benefit analysis to evaluate whether the benefits of introducing a new regulation will outweigh the costs.

A single regulator can be so large that the accompanying bureaucracy makes it unwieldy and inefficient. It also has a great deal of power over financial institutions which can prove dangerous if not checked. Furthermore, any benefits from competition between regulators are lost.

There is also the potential for regulatory forbearance, especially with the FSA’s determination to focus most of its resources on high impact firms. Regulators adopt policies which favour the regulated firms at the expense of the consumer and/or taxpayer, because the regulator, over time, begins to have a vested interest in the survival of the firms it regulates.

Various US authorities have been accused of regulatory forbearance (e.g. the US thrift crisis of the 1980s) and there is no reason why a single regulator might escape the problem. The size of the FSA has caused it to be organised along the lines of functional supervision, i.e. divisions are allocated responsibility in terms of insurance, banking, securities and futures, etc. While this type of organisational form may improve information flows, it increases the danger of regulatory forbearance or collusion between the two parties, if the same regulator(s) are assigned to firms. However, investor protection is a statutory objective, which should counter any tendency for FSA officials to try and protect or collude with badly run financial firms. But the FSA has more contact with the firms it regulates than the public, which could tip the balance away from protection of the consumer.

The statutory objective of investor protection has raised concerns that the FSA may attempt to apply new rules in the wholesale markets, which would undermine London’s international position. To date, the view has been that wholesale customers are financially sophisticated, and therefore, the principle of caveat emptor (let the buyer beware) applies. If considerably less monitoring and regulation is needed for the wholesale markets, compliance costs will be minimised. However, there are many cases where sophisticated investors have found themselves in trouble. For example, corporate finance/treasurers of non-financial firms, on the advice of investment banks, have entered into complex swaps which have subsequently resulted in significant losses. Also, as has been pointed out before, if deposit insurance is limited to retail customers, wholesale depositors will withdraw their money at the first hint of financial trouble.

The FSA is required to meet four quite diverse statutory objectives, and has added duties imposed more recently. Given its limited (especially human) resources, the potential for conflict of interest is high because the FSA may have to sacrifice one of its objectives for another. For example, scarce management resources could result in consumer protection and financial crime being given priority over maintaining stability in financial markets. As a result, firms are less closely monitored than they should be, which could cause more firms getting into difficulty, thereby undermining confidence in the financial sector.

The potential for moral hazard among consumers and financial firms may arise because they believe the FSA is ensuring that risks posed to a sector and the system as a whole is minimised. The incentive to monitor these firms by customers is reduced. Financial firms may think they are fully protected if they implement the regulator’s rules because of a false sense of security. Though moral hazard will be a problem under any type of regulatory regime, it is more likely to arise in a rule based system.

Finally, the MOU between the Bank of England, HM Treasury and the FSA has yet to be tested. Even though the Bank of England is no longer directly involved in regulation, since it is the Bank which will be supplying liquidity in the event of systemic problems, it is critical that the memorandum ensures the requisite information flows between the FSA and the Bank if the Bank is to head off any potential crisis.

Some experts advocate the introduction of a systemic regulator. Banks and other financial institutions would be singled out for special regulation if their failure is likely to pose a systemic risk to the financial infrastructure of the economy. If adopted (at national, European or international level), and the firms falling into this category were made public, then everyone would know which firm was going to be bailed out. Again, moral hazard could be a serious problem if the ‘‘systemic risk’’ firms engaged in led to greater risks and depositors or shareholders were less vigilant in their monitoring.

Is there an optimal way of supervising banks and other financial institutions? The answer is no – most countries mentioned in the opening paragraphs of this have experienced varying degrees of bank crises and/or other problems at some point over the last two decades. Japan’s reforms (see below) are largely a reaction to the financial collapse in that country which began in late 1989. Until ‘‘Big Bang’’, Japan had, effectively, a single regulator. The United States, home of the multiple regulators, experienced serious problems with its thrifts and some banks in the 1980s. Most banks in the Nordic countries came close to being insolvent in the 1980s. The UK and Canada, to date, are part of a small group of countries with no recent history of serious banking problems, though the UK has witnessed some spectacular collapses, notably BCCI (1991) and Barings (1995). These collapses partly contributed to the decision to overhaul the system. It is too early to judge the success or otherwise of the relatively new FSA. The UK’s system of a separate monolithic regulator, which is required to meet four potentially conflicting statutory objectives, has yet to be tested.


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