Read the latest report by the CMA into retail banking.
The growth in high risk trading of extremely complex financial products, including derivatives and options, and the increasing securitisation of assets, created what has widely been dubbed a shadow banking system, which increasingly operated outside of normal banking practices.
Like all large businesses, banks are subject to regulation by the OFT and the Competition Commission. As early as 2001 the Competition Commission concluded that a number of the largest banks operated a complex monopoly in the supply of services to small and medium sized enterprises (SMEs) which resulted in reduced competition to the detriment of the customers. For example, customers were reluctant to switch banks because they all offered very similar benefits.
Background – the tri-partite system
Go to: the new structure
Until the banking crisis, UK banking regulation could be described as light-touch – in other words, regulators do not engage in aggressive regulation, preferring to intervene only when necessary, and only in limited ways.
The main problem for the regulators was that the heavy-touch regulation might force global banks to seek out countries where regulations were less strict. In other words, they would move out of London, leading to huge job losses in the City.
The role of the FSA
Up until 2013, the main UK bank regulator was the Financial Services Authority (FSA). It had two main objectives:
- To promote efficient and fair financial services
- To help consumers of financial services achieve a fair deal
To achieve this the FSA sets standards for the activities of banks and other financial businesses, and can take action to ensure these standards are met.
Rules vs Principles
Some critics of the US regulatory system maintain that it is too ‘rule-based’ and should move towards the European model of ‘principle-based’ regulation.
With rule-based regulation the regulators interpret the rules as laid down in law, and there is little room left for judgment or interpretation.
Under a principles-based system the general principles are contained in legislation, and this gives regulators extra powers to assess the behaviour of financial institutions.
The Banking Act 2009
In order to protect depositors and to maintain financial stability, the Banking Act of 2009 gave those organisations responsible for banking regulation the collective powers to deal with the crisis in the banking system. One of these powers is the ability to put a failing bank under temporary public ownership.
The Turner Review
In March 2009 Lord Turner, Chairman of the FSA, published the findings of his review into the banking crisis and recommended the following:
- A more coordinated international banking regulation, especially the creation of a pan-European regulator.
- Banks to hold more assets.
- Improve regulation of liquidity.
- More information to be collected from those institutions that are part of the shadow banking system, like hedge funds.
- More regulation of overseas banks by host countries – this recommendation is largely in response to the collapse of the Iceland banks, who were unregulated by the UK regulators, but UK citizens suffered large losses.
- Control of bank employees remuneration.
- A review of bank’s accounting practices.
Since the financial crisis, the UK – along with the EU and US – have introduced measures designed to separate the risk-taking aspect of financial markets from the ordinary provision of financial services, as well as strengthen banking regulation. In the EU, the European Banking Authority (EBA) will undertake periodic stress tests of national banks to assess how well they would cope in the future to financial shocks.
In the UK a new regulatory structure governing financial service provision came into effect in April 2013.
Microprudential and macroprudential regulation
Microprudential regulation of UK financial services refers to the regulation and supervision of individual firms in the financial sector, to ensure that they remain solvent and operate in the interests of consumers. In effect, this means ensuring that each bank has a balance sheet which can withstand economic and financial shocks.
Following the Financial Services Act (2012), the Financial Services Authority (FSA) ceased to exist, and the job of microprudential regulation was given over to a new regulatory authority – the Prudential Regulation Authority (PRA). In addition, the creation of the Financial Conduct Authority (FCA) atttempted to maintain high levels of competition in the financial sector.
The Prudential Regulation Authority (PRA)
The main objective of the PRA, which is part of the Bank of England, is to create a stable financial system. To help ensure stability, the PRA was given responsibility for the day-to-day regulation of around 1700 financial institutions, including banks, building societies and credit unions – i.e. ‘deposit-takers’, insurers and large investment firms.
The Financial Conduct Authority (FCA)
The FCA, which is separate from the Bank of England, was given responsibility for ensuring that financial markets work effectively and that the conduct of firms in financial markets is acceptable, and meets the standards laid down in legislation. The FCA is, effectively, the watchdog that ensures competition is maintained, and that banks and other financial institutions do not abuse their dominant positions. The FCA is also responsible for the prudential regulation of financial services firms not supervised by the PRA, including asset managers.
Measures that can be adopted to regulate at the Microprudential level include:
- Ensuring staff are trained to understand risk, and are certified as competent.
- Establishing rules for:
The valuation of financial assets
Assessing the riskiness of assets
- Deciding which assets can be held by institutions.
- Setting rules regarding the trading of assets.
Macroprudential regulation, on the other hand, focuses on the financial system as a whole. According to the IMF, the ultimate objective of macroprudential regulation is to avoid long run losses in wealth by limiting the build-up of system-wide financial risk.
The Financial Policy Committee (FPC)
In the UK, the job of macroprudential regulation under the new framework is the responsibility of the Financial Policy Committee (FPC) of the Bank of England. Its role is to identify, monitor and take action to remove or reduce ‘systemic risk’. The FPC can make recommendations and also give directions to the PRA and the FCA on actions that should be taken to remove or reduce risk. However, the FCA has no direct powers over the individual financial institutions.
One of its main weapons is to undertake periodic ‘stress tests‘ which are designed to asses how effectively the financial system as a whole deals with economic and financial shocks, such as a housing market crash or a sustained recession.
See also: The CMA investigation into retail banking.