By Dr Holly Powley, Lecturer in Law, and Prof Keith Stanton, Professor of Law (University of Bristol Law School).*
The regulation of banks is a difficult and high profile task. The banking industry is complex and plays a fundamental role in the UK’s economy.[1] The financial crisis highlighted the importance of the UK having a regulatory regime that can maintain the health and stability of the banking sector. Banks provide payment and funding services that are central to the successful operation of the modern economy. Regulation therefore needs to ensure that the banking sector is healthy. This blog post will briefly outline the main developments in the UK’s regulatory approach in recent years, and will identify the key areas of concern facing the regulators.
Banking regulation in the United Kingdom underwent significant changes in the years following the financial crisis. It was believed that the regulators had failed to anticipate the crisis and to minimise its consequences. In the period since 2008 UK banks have been embroiled in high profile conduct situations concerning payment protection insurance, LIBOR and foreign exchange rate manipulation and money laundering. The headline reform was the changes to the regulatory structure, represented by the abolition of the integrated regulator, the Financial Services Authority (FSA), and its replacement in 2013 with a twin peaks model consisting of two new regulatory bodies (the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA)).
The two regulators have developed new approaches to the regulation of the banking sector. Principles-based regulation, an approach utilised by the FSA, has evolved into ‘objectives-based regulation’, focusing on threats posed by firms to the regulatory objectives of the FCA and the PRA (as stated in the Financial Services and Markets Act 2000). The exercise of regulation and supervision has shifted from the much-criticised box-ticking approach to focusing on the outcome of the process. Whilst there are legitimate questions over the true distinction between these two approaches, this change in focus has worked comfortably alongside the new emphasis placed on proactive regulation and supervision. This form of modern regulation in the banking sector aims to identify and eliminate problems before they become sources of significant consumer or market detriment. This has been coupled with an emphasis on ‘credible deterrence’ by the FCA, under which enforcement action against banks is widely publicised in an attempt to improve conduct generally across the industry.
The early years of the new regulatory bodies have not only been characterised by a more proactive approach to regulation and supervision. There has also been a willingness to incorporate understandings derived from the field of behavioural economics into regulatory practice. The aim of this is to obtain a better understanding of why consumers and those being regulated make the decisions that they do and, in relation to regulators, to better understand how decisions are made when considering problems.
The regulatory authorities have made substantial progress in addressing the problems identified by the financial crisis in the years after the crisis itself. Not only has the approach to regulation and supervision been honed to acknowledge the need for regulators to identify problems that could arise in the future, but significant regulatory initiatives have also been introduced to strengthen the regulatory regime. On the prudential side, the PRA have been working on improving the stability and resilience of banking institutions. Examples of such work include: addressing problems with capital and liquidity requirements, introducing stress testing, and developing the resolvability of banking institutions. On the conduct side, more rigorous supervision has placed great emphasis on ensuring that firms have a strong risk management framework in place and pay greater attention to the needs of their customers. Measures have also been taken with a view to improving the culture and accountability of individuals working in banks. The introduction of the Senior Managers and Certification Regimes has spanned the work of both Regulators.
However, the position is not a static one. Set against an uncertain political backdrop, both the FCA and the PRA need to be alert to new challenges as they continue to deal with the problems highlighted by the financial and conduct crises.
Political challenges
First, the broader political backdrop needs to be taken into account. The UK has entered a period of uncertainty, with the triggering of Article 50 on 29th March 2017. As yet, it is unclear just how Brexit will impact the operation of banking regulation in the UK, but there are indications that there may be significant upheaval within the banking sector itself as banking institutions currently located in the UK seek to reposition themselves outside of the UK to minimise disruption to their business. There are important questions as to the approach the UK government will take after Brexit. Some degree of deregulation might be seen as a way of tempting banks to stay in the UK but, on the other hand, the desire of institutions to continue to trade in the single market may prove to be a decisive factor in favour of the UK maintaining regulatory equivalence with EU standards.
The global picture must also be taken into account. There are looming questions surrounding reform of financial regulation in the United States, given the Trump Administration’s stated desire to reform the Dodd-Frank Act in order to reduce the regulatory burden. The regularity with which representatives of banking regulatory bodies and central banks have highlighted the importance of maintaining the post-crisis reform momentum in recent months illustrates the concerns that exist as a result of changing attitudes within the US towards the maintenance of global standards for banking regulation and supervision.
The future: challenges
The political backdrop sets the scene for the pressures for the future of domestic and international banking regulation. At domestic level, there are developing tensions in the form of a growing impetus for deregulation. It has always been acknowledged that there is a risk that, as the crisis fades into history, the lessons learnt during that period will gradually be forgotten. Slowly, but surely, arguments advanced against regulation in the pre-crisis days are resurfacing: there have been calls for ‘smarter’ regulation, and the need to ensure the ‘proportionality’ of regulation has been raised. Firms have complained about the cost of compliance, the time burdens associated with compliance, and the uncertainty of regulatory developments. It has been contended that firms are spending more on compliance than on innovation and that this is a reason for the slow growth of productivity in the banking industry.
These attitudes can be demonstrated with a quote taken from a CBI report published in October 2016: ‘The pace and burden of regulatory change is stifling the ability of firms to dedicate meaningful resource to innovation, which is subsequently inflicting damage on the sector, and the wider economy, for the future.’ The CBI emphasise that they are not calling for ‘less’ regulation, but for a stable regulatory regime. There have also been indications that some politicians support the case for a less aggressive approach from the regulators and, as we have seen, the uncertainties surrounding Brexit combined with the importance of the banking sector to the economy, raise concerns that there could be increasing political desire to loosen the regulation that has been developed since 2008.
Specific challenges: FinTech, competition and compliance
A particular issue is the challenges for regulators which new technology is bringing to the industry. The FinTech industry in the UK is an area that has received significant political attention in recent years, as the government has aimed to position the UK as a global FinTech hub. The government has introduced several initiatives to increase the attractiveness of the UK as a market within which to develop innovative financial technologies: the UK has a special envoy for FinTech (Eileen Burbidge), and runs a yearly FinTech event – FinTech week. The 2017 offering, in April, will be the second such event. Support is also provided for new businesses seeking to offer innovative new products and services.
This focus has been reflected in the development of new regulatory initiatives. Within the FCA, the ‘Innovation Hub’ and ‘Project Innovate’ have been created, designed to assist applicant firms seeking to develop and test truly innovative, useful, financial technology. Firms accepted on to the Project Innovate program will be offered assistance from the FCA throughout the development process, and with issues surrounding the regulatory regime. As part of Project Innovate, the FCA have also created the ‘Regulatory Sandbox’, a system intended to allow firms to test new products in real life situations whilst also improving understanding on how the product or service can operate. This also allows the regulator, and the developer, to identify and minimise any potential risks it might create.
To reduce concerns that firms using the Regulatory Sandbox might find themselves subject to FCA enforcement proceedings in the event that the development of a new idea breaches an FCA rule, the FCA also has the ability to issue waivers (as long as the ‘waiver test’, contained in s.138A(4) Financial Services and Markets Act 2000 is satisfied), provide firms with individual guidance on the interpretation of the rules, and can also indicate that it will not take enforcement action (through the use of a ‘No enforcement action’ letter) in certain circumstances.
The Bank of England has set up a similar process, the FinTech Accelerator, to help firms develop new technologies that can help central banking-related activities. The Bank of England has indicated that it has a particular desire to utilise technologies on data management and cyber security. As part of both of these initiatives ‘RegTech’ (or Regulatory Technology) fits within the broader FinTech work, with it intended that new technologies can help both the regulators and the regulated sector.
These initiatives accord with the evolution of the banking sector. Banks in general have a poor public image as a result of the large bail-outs during the financial crisis, and the subsequent conduct issues. They have acknowledged that they have to increase the attractiveness of their products and services to consumers. New businesses have identified this negative public sentiment and are seeking to offer products to challenge the recognised high street banks. Set against the pressures for deregulation, encouraging the development of new technologies to ease the regulatory burden is a positive move. However, there should be concerns.
As Charlotte Hogg noted, ‘there remain real questions around the potential risks and as yet unknown ramifications. As we have seen before, not least during the financial crisis, even the tools considered the most advanced analytically at the time may be flawed’. This warning must be heeded. In a climate where there are pressures for deregulation, the regulatory authorities must ensure that the pendulum does not swing too far in favour of innovation, at the expense of compliance. Regulators need to be alert to the risks that could arise in the operation of these technologies.
The emphasis on financial technology should also lead to questions about the ability of the regulatory authorities to identify where risks lie. It is accepted that there are numerous risks in finance, and that it is impossible to identify all of those risks before they crystallise, but to what extent do the regulatory authorities have the technical expertise to adequately oversee the development and use of FinTech? The need to develop staffing expertise in this area has been acknowledged, particularly by the FCA who have openly stated that the Regulatory Sandbox program enables regulators and developers to understand how the technologies being tested work, but the lessons of 2008 must not be forgotten in this context. While it will not be possible to identify all of the risks, regulators must ensure that they are alert to them.
The tension between innovation and compliance is also represented in the competition sphere. This is another area in which the central motivation originated from governmental policy: the consolidation of banking institutions in the years preceding, and during, the financial crisis, was thought to result in the need for improved competition. The creation of a New Bank Start-up Unit, to be operated by the PRA and FCA, was announced by HM Treasury in July 2015. Statistics available from the Bank of England (page 16) indicate that between April 2013 and March 2016, 12 new banks were granted authorisation, there were 4 new bank authorisations in April 2016, and there are a further 6 applications currently being considered. The PRA has also stated that there are an additional 14 interested applicants.
The New Bank Start-up Unit guides prospective new banks through the application and authorisation process, and has introduced a new element entitled ‘modification’, enabling new market entrants to start offering products and services to consumers without having the framework of a full bank in place, provided that they can demonstrate that they will be able to meet the PRA and FCA requirements for entry to the market within a set time frame. There are normally restrictions placed on the business that a new bank can undertake during this period.
The introduction of the New Bank Start-up Unit addresses some of the concerns that surrounded access to the banking sector for new entrants, particularly in light of the high financial expenditure new entrants would be required to make to demonstrate they had the infrastructure in place before being granted authorisation. However, the New Bank Start-up Unit does not allay, or address, problems experienced by new banks once they have received authorisation. PwC recently published an in-depth report into ‘challenger’ banks in the UK, and highlighted several of the problems faced by new banks, once they have received authorisation and are trying to develop their business.
PwC argue that challenger banks experience difficulty with the capital requirements they are obliged to comply with, as a result of their smaller status; new market entrants are required to hold a higher proportion of capital as a result of the differences between the Internal Ratings Based approach utilised by established banks, and the Standardised Approach new entrants have to demonstrate compliance with.
Alongside this issue, the PwC report highlights that challenger banks believe that regulatory compliance is disproportionately costly and time consuming for them, given the smaller size of their compliance departments in comparison with their larger, more established, peers. Further, there are questions surrounding access to the payment systems which new banks have to use in order to offer retail banking services. This issue has also been identified by the Payment Services Regulator (PSR), and it is hoped that the development of the faster payments system, as well as the introduction of the Second Payment Services Directive should ease some of the tensions in this area. It is an issue that needs to be monitored.
The overarching challenge being faced by challenger banks is that of resilience. If these new banking institutions are to survive, they need to have the ability to do so, yet in a way that accords with the objectives of the regulatory regime. The pressures on business development and compliance have resulted in a situation where challenger banks, as highlighted by the PwC report, “think the regulator should focus on enabling smaller players to take risks that will have a smaller impact – and even if they fail, such exercises provide learning opportunities for the industry.”
Conclusion
It is clear that the UK’s regulatory regime has made significant steps since 2008. It is important that the emphasis on addressing the problems identified during the crisis continues. However, if the UK is to continue to operate as a global financial centre, the challenges highlighted in this blog need to be addressed. Regulators have demonstrated that they are aware of the developing issues, yet, they must ensure that any external pressure to reduce regulatory requirements is resisted. Developments with FinTech and enhanced competition within the banking sector have the potential to bring great benefits to consumers and regulated firms alike, although it must be ensured that compliance is not traded for innovation in the course of harnessing these benefits. The UK needs to ensure that it continues to recall the lessons learned from the financial crisis. In this context, the balance between risk awareness and being risk averse is central.
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[1] The Financial Conduct Authority states that financial services currently provide 12% of the UK’s total economic output. Financial Conduct Authority, Our Future Mission, 2016, p 9.
* This blog post is derived from a paper presented by Holly Powley and Keith Stanton at the Future of Financial Law Conference in Jersey, organised by the Institute of Law, Jersey, on 24th March 2017. Full conference proceedings will be published in due course.