What does the future hold for financial regulation? Gavin Stewart summarises the current situation and the changes that are coming soon.
Change is in the air for financial regulation. As well as Her Majesty's Treasury (HMT) consultation on the post-Brexit Future Regulatory Framework (FRF), there is the much-heralded 'transformation' of the Financial Conduct Authority (FCA), under its new CEO, Nikhil Rathi. And, with rather less fanfare, the Prudential Regulation Authority (PRA) and Bank of England (BoE) are also working to implement the 2019 Future of Finance report.
The broad aims of these changes, including increasing regulators’ accountability to parliament and digitising regulation, are easy to support. But detail is - so far - scant, and the reality of regulatory transformation doesn't always live up to the rhetoric, so it's worth exploring the prizes on offer from modernisation, as well as the challenges involved.
Importantly, today’s modernisation effort isn't taking place in a stable environment. The COVID-19 situation is changing the practice of financial regulation, which - like much of the economy - is being put under enormous pressure. And the thinking behind the various strands of modernisation predates coronavirus, so their implementation will need to adjust to the changed circumstances.
One of these is unprecedented co-ordination between HMT and the regulators with, for example, the FCA introducing and then extending temporary regulations around mortgages and consumer credit payments in lockstep with HMT’s furlough schemes. This co-ordination is probably justified by the scale of the circumstances, but it raises important questions about regulatory independence in the long term.
Modernisation also needs to better reflect the dynamic nature of the financial services industry, rather than have its predominant focus on the regulator’s internal needs, a feature of several previous programmes, including the design of the FCA itself in 2013. The recommendations of the recent independent reviews of its regulation of London Capital & Finance (LCF) and Connaught respectively are an additional, complicating factor for the FCA.
If the challenges are daunting, however, the opportunities presented by modernisation are also huge. They can be grouped under three broad headings:
The fundamentals of the FCA’s operating model are little changed from the FSA’s 2004 structure, and its four main functions - policy, authorisation, supervision and enforcement – still operate semi-autonomously and are organised differently from each other. Subsequent restructurings have built from the existing model (eg, adding competition and consumer credit), rather than starting from first principles and, overall, this has made management more complicated. Working across the silos is difficult.
As a result, there is considerable scope for simpler structure and governance, de-duplication and better internal collaboration. The FCA is bringing policy together with supervision and authorisation, which is a good first step, but the hard yards will be in aligning processes and decision making.
Meanwhile, the PRA’s semi-detached relationship with the rest of the BoE helps manage potential conflicts of interest, but is inefficient as regards data, where monetary and financial stability have distinctive needs. The BoE also has its own share of silos, partly dictated by the different roles a central bank performs, and there is a broad recognition it could make better use of the data it already holds.
If any of this were easy, however, it would have happened already, and there are many banana skins to avoid. The wide scope of the FCA’s remit, the multiple roles of a central bank, and the continual evolution of financial services all contribute to the difficulty, while statutory requirements and the need for clear accountability mean governance requirements will always be onerous.
Neither does it necessarily follow that greater efficiency will lead to lower cost, and clearing the fog around a problem can mean regulators act earlier and more often. It's not obvious, for example, that an FCA operating model capable of dealing more successfully with LCF would be less expensive than the existing one.
Digitisation is the foundation of the modernisation push and is the obvious way forward for regulation, enabling it to work from data that is more complete, accurate, precise and timely. It might also usher in an era of greater partnership and collaboration with the industry, on the basis that new regulation is better designed and targeted, with lower indirect costs to the industry.
However, the explicit regulatory benefits of digitisation are rarely set out, beyond the idea that digital reporting by firms would deliver future cost savings. This matters because both regulators and the industry will need to make a significant initial investment, so there needs to be widespread confidence that digitisation will produce better results.
In practice, this means it must deliver some combination of better anticipation and prevention of problems, and reduction in the damage they cause. An early test will be whether regulators can successfully join up the data they already hold with new data they might collect in the future.
To succeed, modernisation will also need to be owned by those implementing it on the ground. Because regulators don't have an easily measurable bottom line, it is common for internal change programmes to be imposed as top-down solutions, without always convincing those implementing the change that it's worth the effort. This would be a particular mistake with digitisation due to the scale of the institutional and personal change required.
As a side note, because reporting definitions will be more precise, it may become easier for firms to submit more granular data, not less. This is the opposite of the “less is better” mantra that is usually assumed, and there may be other such surprises along the way.
Lastly, experience through coronavirus lockdown is demonstrating the advantages of the PRA and FCA co-ordinating their work; as examples, joint calls with firms are now the norm, and the PRA has been assisting the FCA on the prudential side. These new ways of working have been a demonstrable success and modernisation should integrate them into our 'twin peaks' model.
The major challenges of the future re-inforce this message. From operational resilience to climate risk, they require close co-ordination between the two regulators, as will the eventual exit strategy from the coronavirus situation.
For example, the PRA and FCA will need to work closely on what levels of forbearance firms should extend to vulnerable consumers and how any resulting losses are recognised in firms’ provisioning.
Now is the right moment for regulators to modernise. Their core operating models were designed some time ago for a different set of needs, and digitisation offers a huge opportunity to improve both the practice and results of regulation. At the same time, coronavirus has been a crucible for forging better co-ordination between the PRA and FCA, and this should be baked into future practice.
Although the starting gun on modernisation has been fired, however, there doesn't yet seem to be a credible implementation plan, and it will be critical to win the hearts and minds of those most affected and whose engagement is most needed to make it work.
A version of this article was previously published by Thomson Reuters Regulatory Intelligence on 13 January 2020.