Hector Sants outlines blueprint for future regulation

In a conference speech on 13 December 2010, Hector Sants, current Chief Executive of the FSA? and nominated Chief Executive of its successor the Prudential Regulation Authority (PRA), gave some interesting indications about the changing shape of UK regulation.

We have listed some key points below. To read the speech in full, click here.

The Prudential Regulation Authority (PRA)

Scope
The PRA's primary objective will be to "promote the stable and prudent operation of the financial system through effective regulation of financial firms . . . orderly failure with minimal cost to the economy should not be seen as a regulatory failure.  The PRA should be judged by the avoidance of failures which incur a cost to the economy and in particular to individual tax payers and customers."

The PRA will be responsible for the prudential supervision of:

    •    banks;
    •    building societies;
    •    insurers;
    •    friendly societies;
    •    credit unions;
    •    Lloyd’s of London and its managing agents; and
    •    investment banks.

Thus there are some 2,200 firms in the PRA’s scope.

The PRA will build on the FSA’s recently developed approaches of intrusive and judgement-based supervision and credible deterrence.

Approach to supervision
The PRA will focus on reducing the impact of a firm failing, rather than the probability. But for high impact firms "given that – even with resolution tools – the impact of failure is uncertain, the PRA will have a low tolerance for such events.  It will focus supervisory resource, particularly senior management resource, on delivering intensive, intrusive, judgement-based supervision focusing on issues that really matter to the safety and soundness of the firm."

To put this risk management approach into practice, the PRA will develop a new risk model, which requires supervisors to make judgements:

    •    on the gross impact of firm failure;
    •    on business models;
    •    on systems and controls, culture, senior management and governance;
    •    on capital, liquidity and asset quality; and crucially
    •    on resolution planning.

"Moving to this risk model will therefore mark an important change from current practice, with forward-looking analysis on the basis of a balance of risks and focus on resolvability becoming core parts of the model."

Where necessary the PRA will "conduct its own indepth stress testing to ensure its judgements are not reliant on firms’ own capabilities.  The financial crisis has clearly demonstrated that, in reaching their own conclusions, regulators should not rely solely on the judgements made by firms, or indeed their auditors."

Policy
Policy making within the PRA will need to facilitate the judgement-based supervisory approach. There will be particular emphasis within the PRA on engaging with European bodies.

Simplified rulebook?
"A particular focus of our initial thinking has been around establishing whether a slimmer, more purposive and accessible rule book can be produced for the PRA.  The PRA will not do away with rules altogether, but an important change in focus for the PRA will be in ensuring that it is clear to all what purpose its prudential rules are intended to achieve.  We expect to review the prudential aspect of the current FSA Handbook with a view to achieving this end, subject to constraints imposed by EU directives – as well as in making the material shorter and easier to navigate."

Principles based?
"In many respects, the regulatory philosophy of the PRA is an evolution of the current approach taken by the FSA – particularly with respect to intensive and judgement-based supervision . . . there will be greater emphasis in future that, for prudential regulation, the rules are primarily standards designed to minimise risks to an institution’s soundness and sustainability, and emphasise that regulators and firm management should focus on adherence to their purpose and substance."


The Consumer Protection and Markets Authority (CPMA)

Scope
The thinking is "somewhat greener" here!

The CPMA will have responsibility for the regulation of conduct in wholesale, as well as retail, financial markets and of the infrastructure that supports those markets, combined with a particular focus on protecting consumers.

The CPMA will also have responsibility for the prudential regulation of all firms which do not fall under either the PRA’s scope or the market infrastructure responsibilities of the rest of the Bank.

This means the CPMA will have prudential and conduct of business regulation responsibilities for approximately 25,000 firms, and responsibility for the conduct regulation of the 2,200 firms which are prudentially regulated by the PRA.

A consumer champion?
"The CPMA is being set up with the clear intent of securing better outcomes for consumers . . . prepared to intervene as soon as potential concerns begin to emerge and having a willingness to take a greater risk of being overturned on appeal if it thinks that early intervention is warranted . . .  the CPMA will pursue a more aggressive consumer protection agenda . . . the CPMA will need to be given more powers of intervention and disclosure than the FSA currently has."

Approach to supervision

• premium on early risk identification and prioritisation
• build on successful FSA initiatives, such as the approach to smaller firm supervision and  more recent conduct strategy
• recognise that "the historic FSA strategy of focusing on high-level systems and controls and information disclosure to consumers has not proved effective." 

"The CPMA should be judged on the degree to which it minimises the amount of consumer detriment . . . In future, the CPMA must therefore have a lower risk tolerance than that of the FSA."

Change of focus
"In practice, the CPMA’s regulatory approach will involve . . . earlier intervention in the product chain and a shift away from reliance on firms’ own systems and controls and on disclosure to minimise risks."

ARROW 3?
"A key point here, however, is that the shift from firm-specific to thematic industry-wide intervention will not be at the expense of maintaining a core inspection programme.  Such programmes have been shown to have valuable deterrence and informational value.  The FSA currently visits all firms, regardless of size, on a four-year cycle, with those firms receiving a full ARROW assessment being visited every two years.  At a minimum we would expect this cycle to be maintained."

Supervision of wholesale markets
In addition to the CPMA’s consumer protection role, the CPMA will be responsible for the regulation of conduct in wholesale financial markets and of the infrastructure that supports those markets.
 
"I believe that the CPMA should be prepared to intervene early to deal with emerging wholesale conduct issues that threaten market integrity, particularly where these have a link to retail markets and consumers, and if necessary develop additional regulatory requirements for wholesale market participants where market discipline alone is not delivering appropriate standards.  With its increased focus on conduct issues, I would expect the CPMA to . . . give more attention to this area than has been the case for the FSA in recent years."

Policy
In relation to policy making, like the PRA, the CPMA will operate in an environment where the majority of policy will be formulated at the EU level.
 
More prescription?
"Another key element of the CPMA’s approach to policy making will be striking the right balance between rules and principles.  A mix will be required to ensure effective deterrence and redress.  Work is already underway to identify those risks where the prescription that rules provide is the most effective way to protect consumers and, conversely, where firms and consumers alike would benefit from the flexibility that comes from guidance and principles.  Overall, in contrast to the FSA, it is likely that there will be a shift towards more detailed prescription."

Coordination?
"We are aware of industry concerns about an increased regulatory burden, and about having to meet different and possibly conflicting standards.  It is in the interests of the regulators, the industry and consumers that the PRA and CPMA coordinate effectively.  We envisage making this a reality through a number of mechanisms, including:

• a high-level memorandum of understanding, with detailed annexes covering potential high-risk areas;
• domestic colleges for joint working on the supervision of individual firms;
• cross representation on policy boards; and
• legal provision for information gateways."

Transition
"The FSA has already started to evolve towards this new structure.  In April 2011 we will replace our current Risk and Supervision business units with a Prudential business unit and a Consumer Protection and Markets business unit.  From this point we will then take a progressive approach to changing those regulatory processes that can be changed within our existing statutory remit so that the FSA can begin to operate a more ‘twin peaks’ style of regulation."