The new face of financial regulation

Having already undergone fundamental changes in the wake of the global financial crisis, the UK's FSA is set for an even bigger overhaul, when its responsibilities are assumed by three new bodies: the Prudential Regulatory Authority (PRA), the Consumer Protection and Markets Authority (CPMA) and the Financial Policy Committee.

But how will the regulatory approach of this new regime differ from that of the FSA, and how will regulated entities perceive the changes?

The more things change ...

Chief executive of the FSA Hector Sants, who will manage the transition and be the first chief executive of the new PRA, pointed out that the work the FSA has already done to bolster regulations will be enshrined in the new regime and built on.

“In the UK, significant progress has been made on improving supervisory effectiveness,” Sants said at a recent event hosted by Thomson Reuters. “The FSA has radically changed over the past three years. It is now operating a more intensive approach to supervision, which is designed to deliver a proactive, not reactive outcomes-based supervision.”

Sants added: “In many respects, the regulatory philosophy of the PRA is similar to that of the recent approach of the FSA, particularly with regard to intensive and judgment-based supervision.”

New priorities

One difference will be the PRA’s narrower focus. Some 2,200 firms will fall within its scope. These will include banks, building societies, insurers, friendly societies, credit unions, Lloyd’s and its managing agents, and investment banks.

Furthermore, the PRA will not regulate market conduct – it will focus solely on ensuring the smooth running of the financial market through individual company supervision.

The 25,000 firms that fall outside the PRA’s scope, such as brokers, intermediaries and advisers, will be overseen by the CPMA, which will also regulate the conduct of the 2,200 companies under the PRA’s remit.

The key difference between the FSA and the PRA, however, will be the new entity’s acceptance of company failure, and the fact that this acceptance will be explicitly written into the PRA’s goals.

Admitting defeat

“The proposed wording for the PRA statutory objective contemplates that firms will fail, and charges the PRA with making sure that, when failure occurs, it happens in a way that minimises disruption to the financial system,” Sants said. “To reflect this approach, the PRA is likely to spend a relatively higher proportion of its resources on reducing the impact of firm failure than the FSA has done, and relatively less on reducing the probability of failure.”

For companies whose failure poses a low risk to the overall financial system, the PRA’s regulation will focus on resolvability of the firm, monitoring compliance with rules and reacting to issues, Sants said. For so-called medium-impact firms, where the PRA will also tolerate failure, the PRA will seek to reduce both the probability and impact of failure.

For high-impact firms, where the PRA has the lowest tolerance for failure, the PRA “will focus supervisory resource – particularly senior management resource – on delivering intensive, intrusive judgment-based supervision, focusing on issues that really matter to the safety and soundness of the firm,” Sants said.

The PRA’s supervisors will assess a company’s gross impact and assess whether it could be wound up to avoid disrupting the system, Sants said. “Moving to this risk model will mark an important change from current practice, with forward-looking analylsis on the basis of a balance of risk and a focus on resolvability becoming the core parts of the model.”

Learning from past mistakes

The PRA and the special resolution unit of the Bank of England will also develop a new formal intervention framework to ensure that concerns about individual firms are conveyed and remedial action is taken at an early stage.

"The framework will have two purposes: first, it would require firms to take appropriate remedial action to reduce the probability of failure,” Sants said. “Secondly, it will flag the need for action to be taken by the authorities so that a failure or a resolution of the firm will occur in an orderly manner that causes minimum disruption and cost to the financial system and individual customers.”

Above all, Sants is keen that the new regime is not seen to be regulating for regulation’s sake and does not fall into some of the traps that caught its predecessor. “The FSA was in the past susceptible to accusations of tick-box regulation, and it is vitally important that the PRA puts itself beyond the risk of such criticism,” he said.