In July 2010, the Treasury published a consultation document, 'A new approach to financial regulation: judgement, focus and stability', proposing changes to financial regulation in the United Kingdom.
The Government proposes to do away with the tripartite system, in which the Treasury, Bank of England, and Financial Services Authority work together, replacing it with a ‘twin peaks’ structure, separating macro-prudential and conduct of business regulation.
Today’s Report is the Committee’s response to what has been set out so far with regard to those proposals.
The Government’s timetable
The Government has said that it wishes the legislation to be introduced in “mid 2011” and to be completed by 2012.
The Committee is concerned about the risks involved in such an ambitious timetable and the Report underlines the importance of getting reform of financial regulation right.
The legislation to establish the new regulatory structure should be subject to pre-legislative scrutiny, over a reasonable timescale.
Even with proper pre-legislative scrutiny, once introduced, the timetable for the Bill should be generous enough to allow proper parliamentary consideration, using carry-over if necessary.
The Committee welcomes the establishment of the Independent Commission on Banking and notes that its work may well have a bearing on the shape of regulation required. The Report recommends that the Government pay full regard to the ICB before coming to conclusions on financial regulation. This also has implications for the timetable set out.
The Committee welcomes the Government’s suggestion that FSMA could be revisited in its entirety.
The Report calls on the Government to present a new Bill only after full consideration has been given to responses to initial consultation. Drafting the legislation will then be likely to secure a more coherent final product.
Treasury Committee Chairman Andrew Tyrie said:
"In light of the banking crisis, the Government is rightly proposing radical changes to the way in which financial services are regulated. However, having examined the initial proposals, the Committee’s overriding concern is about the proposed speed of implementation. It is vital to maintain the momentum for reform, but there is no point in flawed change. In any case, these proposals need to be considered in conjunction with the ICB. Regulatory reform will almost certainly not be enough; the Government will also need firmness of purpose should the ICB recommend structural reform."
A super regulator - the Bank of England
The Government proposes to give a Financial Policy Committee (FPC), based in the Bank of England, power to monitor the system to ensure financial stability, and to take action when that stability is threatened.
There are sound reasons for insulating economic policy decisions from short-term political pressures. However, the Report underlines the importance of democratic accountability.
Moreover, 'financial stability' is a very broad concept, and may be hard to define in practice. The Report calls on the Government to give much more detail about what it considers constitutes financial stability.
The macro-prudential tools which the FPC is to use are as yet undefined and untested, and may have unexpected consequences. The Government must also decide which macro-prudential tools it proposes to make available to the FPC.
The Committee welcomes the fact that the Government is going to set out these macro-prudential tools in secondary legislation and calls for that legislation to be published as soon as possible so that Parliament can assess the nature of the powers to be devolved to the FPC.
The accountability of the Monetary Policy Committee is secured by its extremely clear remit, and the mechanism for exchanging letters with the Chancellor if inflation breaches the target.
In addition, the Bank of England has engaged with the Treasury Committee in an exemplary way to achieve accountability to Parliament. The need for secrecy, among other things, will mean that the accountability of the FPC will be different from that of the MPC.
The Committee will consider what is required to secure FPC accountability in the light of more detail on the Government’s reform proposals.
Given the high profile, yet uncertain nature of its tasks, it will be essential that the FPC has a strong core of credible external members and contains at least one person with recent experience of risk management at the highest level.
The Report calls on the Government to reconsider the balance between Bank personnel and external members and provide a fuller explanation of the reason for including two bank executives as part of the FPC.
Andrew Tyrie said:
"Until now, financial stability has been seen as the ultimate responsibility of the elected Government. These proposals make the Bank of England a 'super-regulator.' If the Financial Policy Committee is to be given lead responsibility for securing financial stability, the Government needs to provide clarity about what such stability means.
Such a large transfer of power also necessitates robust accountability. There is a clear structure by which the MPC is held accountable to Parliament. The structure for the FPC will have to differ from that for the MPC, but it is of no less importance. In order to ensure challenge is embedded within the FPC we would also like to see better balance of external members. The Committee will return to the issue of democratic accountability."
Prudential Regulation Autority and Consumer Protection and Markets Authority
The Government proposes to establish a prudential regulator, the Prudential Regulation Authority, as a subsidiary of the Bank of England. Financial stability does not mean that firms will not fail; it means that failures can take place without threatening the system as a whole.
In the absence of further explanation, suggestions that the authority would have a "low tolerance" for the failure of systemically important institutions imply the opposite.
The Consumer Protection and Markets Authority (CPMA) will regulate the conduct of financial institutions. Proper regulation of conduct should in itself produce good outcomes for consumers.
However, the Report concludes that branding the CPMA as a 'consumer champion' would be inappropriate, confusing, and potentially dangerous.
The job of the regulator is to ensure regulation is effective and proportionate. That requires a balance between preventing abusive behaviour and ensuring that regulation does not impose excessive costs and restrictions. Financial markets are primarily about the management and pricing of risk, not its removal.
However, the Report recommends that the CPMA should have competition as an objective. This will benefit consumers directly and indirectly. Not only will there be a greater choice available for consumers, but the transparency which effective competition brings should reduce the need for heavy handed regulation. Greater competition should also help prevent firms becoming too big to fail.
The Report also draws attention to the importance of markets regulation, and welcomes the Government decision not to separate the UK Listing Authority from other markets regulation. It emphasises the need for a strong market division within the CPMA.
The financial crisis has resulted in a sharp increase in the direct costs of regulation. The indirect costs have doubtless increased further, although they remain difficult to quantify.
The Committee is concerned that the proposals say little about the cost of regulation, or about the non-bank sector. The Report warns that regulatory changes should not be considered without proper evaluation of both their direct and indirect costs.
Andrew Tyrie said:
"Much more attention needs to be paid to the indirect or hidden cost of regulation imposed on firms but ultimately always borne by the consumer. That’s why the CPMA needs a competition objective. It is regrettable the Government’s consultation paper said so little about costs. More work is needed to find ways to establish the true cost of regulation and the Committee will be pushing the new regulator to ensure this is done."