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Part IV Regulatory and Other Developments in the UK 2010‒2016, 13 Financial Services Act 2012: Changes to the Regulatory Architecture

Roger Mccormick, Chris Stears

From: Legal and Conduct Risk in the Financial Markets (3rd Edition)

Roger McCormick, Chris Stears

From: Oxford Legal Research Library (http://olrl.ouplaw.com). (c) Oxford University Press, 2021. All Rights Reserved. Subscriber: null; date: 15 April 2021

Subject(s):
Banking — Financial Services and Markets Act 2000 — Bank of England

(p. 251) 13  Financial Services Act 2012

Changes to the Regulatory Architecture

A responsible and well-regulated financial services sector is essential to the success of the UK’s economy. The financial crisis of 2008 and 2009 demonstrated that when things go wrong in the financial sector, the impact on the economy can be severe. We are committed to a fundamental overhaul of regulation to make sure that the financial sector manages and contains risks more effectively.1

13.01  Such was the scale and speed of the Financial Crisis and the fear of financial ‘contagion’ that many of the past intellectual assumptions as to (i) how global markets operate, (ii) how financial conduct and risk is assessed, monitored, and managed, and (iii) how the supervisory regime and regulatory architecture operated for the entire financial services industry were seen by many to be manifestly flawed and inappropriate. Indeed, the revelations of the LIBOR scandal that shocked the regulatory and political establishment to its core was a catalytic ‘conduct-related’ event that brought about a significant change in regulatory mind-set from one focused on bank safety and stability, to one of bank conduct, and the control thereof.2

13.02  Institutional regulators across the globe were arguably caught out of their depth by (i) the scale and complexity of modern financial product engineering, (ii) the implications of global credit expansion, (iii) the evolution that had occurred in (p. 252) the nature, scale and relevance of the critical factors that were driving and or materially modifying the development of financial markets, and (iv) other socio-economic conditions that preceded and precipitated the Financial and Conduct Crises. Regulators had, it seemed, become, almost by stealth, greatly under resourced,3 inadequately focussed, and inappropriately structured to oversee what had become exponentially evolving events and a pattern of ‘culture driven’ behaviour that, with the benefit of hindsight, looked like a disaster waiting to happen.

13.03  The Turner Review,4 which was generally well received within the UK,5 coincided with a continuing worsening of banking liquidity across all of the main global markets. Indeed, one month after Turner reported, the G20 gathered at an emergency session, in which it announced a global stimulus package worth an aggregate of USD 5 trillion.6

13.04  Creative and unprecedented central bank intervention aside, the stage was set for a new system of regulation. Turner heralded a shift from what was perceived as light touch and ‘principles based’ regulation to a more intrusive judgement-led and outcomes-focused approach, equipped to tackle macro-prudential and systemic risk in equal measure to the risks posed by individual institutions.7 This chapter charts the passage of the resultant legislation—the Financial Services Act 2012 (FSA 2012)—from its policy conception through its consultation phase, and to its enactment.

(p. 253) A.  A Prescription for Better Financial Regulation

13.05  Following the General Election in May 2010, the newly formed Coalition Government (Conservatives and Liberal Democrats) swiftly produced its ‘Programme for Government’ policy statement,8 which, among other things, set forth an ambitious schedule to build a ‘new economy from the rubble of the old’ and committed to a radical ‘reform of our broken banking system’.9 The statement cited that the current system of financial regulation was fundamentally flawed and needed to be replaced with a framework that promoted responsible and sustainable banking, where regulators had greater powers to curb unsustainable lending practices and to promote more competition in the banking sector. The programme additionally recognized the need to ‘protect taxpayers from financial malpractice and to help the public manage their own debts’.10

13.06  In the months leading up to the General Election of May 2010, the UK had already moved at a brisk pace to effect financial market reform. However, it was not until George Osborne (the then Chancellor of the Exchequer) gave his 16 June 2010 Mansion House speech,11 that the extent of regulatory changes became clear. Osborne outlined reforms that would include:

  1. (1)  The abolition of the tripartite system of regulation (ie the sharing of responsibility for financial services regulation between the Bank of England, the FSA, and HM Government), replacing it with a ‘twin peaks’ regulatory approach which separates prudential regulation from consumer protection and market conduct matters.12

  2. (2)  The transferring of responsibility for micro-prudential regulation (that is, the safety and soundness of individual banking institutions) from the FSA to a new prudential regulator (‘the Prudential Regulation Authority’ (PRA)), (p. 254) established as a subsidiary of the Bank of England. This was to resolve the issue, as Osborne put it, of the FSA becoming ‘a narrow regulator, almost entirely focused on rules based regulation’, and that, among other issues, it was apparent that ‘no one was controlling levels of debt, and when the crunch came no one knew who was in charge’.

  3. (3)  Establishing a new Financial Policy Committee (FPC) within the Bank of England, that would have responsibility for macro-prudential regulation and financial stability.13 Osborne specifically remarked that ‘only independent central banks have the broad macro-economic understanding, the authority and the knowledge required to make the kind of macro-prudential judgment that are required now and in the future’ and that this judgement must be exercised in light of the micro-prudential insights into the specific institutions that it may have to support (as a lender of last resort).

  4. (4)  Establishing a new ‘Consumer Protection and Markets Authority’ (this was subsequently changed to the Financial Conduct Authority) which will have responsibility for (a) regulating the conduct of authorized firms, (b) market supervision and regulation, and (c) consumer protection.

  5. (5)  Establishing a white collar crime agency formed out of the Office of Fair Trading, the FSA, and the Serious Fraud Office. This agency14 would investigate and prosecute corporate white collar crime, including fraud, insider dealing, market abuse, and money laundering.

  6. (6)  Introduction of a banking levy (or balance sheet tax) and a demand for the curbing of pay and bonuses within the financial services industry.

  7. (7)  Establishing an independent commission on the banking industry with the purpose of examining the merits and practicality of separating retail banking from investment banking.

B.  ‘A New Approach to Financial Regulation’: The Consultation Phase

13.07  In early July 2010, the UK Government commenced its formal consultation process on proposed changes to the UK regulatory framework, as headlined by Osborne. There were, ultimately, three distinct consultation phases, which preceded the formal publication of the FSA 2012 itself.

(p. 255) 13.08  The phase 1 consultation report published in November 2010 was entitled ‘A New Approach to Financial Regulation: Judgement, Focus and Stability’15 and rehearsed the Government’s views on the causes of the financial crisis:

  • •  global economic imbalances;

  • •  mispriced and misunderstood risk;

  • •  unsustainable funding and business models for banks;

  • •  excessive build-up of debt across the financial system; and

  • •  the growth of an unregulated ‘shadow banking’ system.

13.09  The consultation document further confirmed the Government’s plan to replace the FSA with the Financial Policy Committee (FPC), to introduce the Prudential Regulation Authority (as a limited company, wholly owned by the Bank of England) and the FCA, through a raft of reforms. Notably:

  • •  The FPC would be responsible for the identification, assessment, and management of macro-prudential (or systemic) risk,16 issuing recommendations (and in certain circumstances, issue directions) to the other authorities in order to reduce imbalances and weaknesses in the financial system. The macro-prudential tools at the FPC’s disposal was highlighted as the adoption of the Basel 3 countercyclical capital requirements; variable risk-weights; leverage limits; forward-looking loss provisioning; collateral requirements; and quantitative credit controls and reserve requirements.

  • •  The PRA would have operational responsibility for the micro-prudential regulation of all deposit-taking institutions, insurers, and investment banks. With the PRA working alongside (and pursuant to directions from) the FPC, under a single institution, the Government sought to bridge a gap in responsibilities where systemic risk concerns require collective actions by individual firms. For example, ‘the FPC may require an increase in the capital held by firms during an upswing in the credit cycle. The PRA would implement this change and monitor compliance through its supervisory function.’17 As the prudential regulator, the PRA would also represent the UK at the European Supervisory Authorities (ESAs).18 The Bank of England (through the PRA) would also (p. 256) have market infrastructure responsibilities such as those relating to the regulation and supervision of settlement systems and central counterparty clearing houses.

  • •  The FCA would be responsible for the ‘regulation of conduct within the financial system—including the conduct of firms towards their retail customer, and the conduct of participants in wholesale financial markets’.19 This mandate would be underpinned by a statutory objective to promote confidence in financial services and markets through its responsibility for consumer protection and market integrity. The policies and decisions of the FCA would have to ‘have regard’ to the objectives of the other regulatory authorities,20 principles of good regulation, and other important linked matters which relate to the public interest.21 Furthermore, the FCA would be responsible for the authorization (and prudential supervision) of firms not otherwise authorized (or prudentially regulated) by the PRA. The authority would also have administrative functions relating to the raising of levies to fund the regulators (and the FOS, FSCS); responsibility for the regulation of exchanges and other trading platform providers; and its markets division would host the UK Listing Authority (UKLA).

13.10  As information sharing among these new authorities was deemed essential to the efficacy, stability, and efficiency of the new framework, close co-operation was inherent in the design of the respective authorities’ mandates and, in the reporting matrix within the Bank of England and beyond, to the UK Treasury (where systemically necessary).

13.11  The Government received over 200 responses to its Phase 1 consultation, from financial services firms, including banks, building societies, insurance firms, independent financial advisers, exchanges, brokers and related trade associations, as well as consumer representatives. Responses were generally supportive of the Government’s interpretation of the cause of the financial crisis and in the (p. 257) proposed new regulatory framework but questions and critique were expressed that included:

  • •  Would such a major change in ‘framework’, with all the disruption and new compliance expense that would arise across the industry, really provide the systemic security and protection that ‘the public seek’?

  • •  Concern was expressed that the consultation document contained too little detail on how the new regulatory framework would lead to operational excellence.

  • •  Concerns were expressed that the ‘framework’ and associated new rules and regulations would potentially stifle product and business development innovation, including outsourcing. The ability to balance risk (including, importantly, legal and conduct risk) with the promotion of innovation and fair competition was noted as essential.

  • •  Would the new agencies actually work in a controlled, coordinated, and efficient way and not create an overly bureaucratic bottleneck to ‘doing business’, in which creativity and time to market is often of the essence?

  • •  Concerns were expressed that the consultation paper was surprisingly light on the measures that will be taken to address the over reliance on ‘tick box’ compliance. Changing the regulatory framework was not a guarantee of an improved outcome.

  • •  More emphasis should be put on accountability, best practice in self supervision, and measures to promote communication and cooperation between the PRA and the CPMA.

  • •  Concerns were expressed that the tone of the consultation document suggested that HM Treasury believed that restructuring the regulatory framework would eliminate regulatory failure. It would not.

13.12  In February 2011—informed by responses to the Phase 1 consultation—the Government presented its second, updated consultation document, ‘[A] New Approach to Financial Regulation: Building a Stronger System’,22 following which, the Government received over 150 responses. Responses were substantially in agreement with the proposals, albeit those consulted requested further qualification and clarification on:

  • •  the need for the regulatory authorities’ core statutory objectives to be balanced and supplemented with other factors;

  • •  the importance of accountability and transparency for the PRA, the FCA, and the FPC;

  • •  the need for a strong, coherent markets regulation function within the FCA, including the functions of the UKLA;

  • (p. 258) •  the importance of the European and international agenda, both during the transition phase and in steady state; and

  • •  the importance of effective coordination between the new regulatory authorities.

13.13  The consultation closed with the Government’s publication, in June 2011, of its third document, entitled, ‘[A] New Approach to Financial Regulation: The Blueprint for Reform’.23 The document included a draft Financial Services Bill which contained some of the provisions needed to give effect to the reformed regulatory framework. In December 2011, George Osborne presented to Parliament his statement on ‘Banking Reform’, in which he formally announced the Government’s most far reaching reforms of British banking in modern history, commencing with the Financial Services Act 2012 and moving thereafter, into deeper structural reform—issues that were the focus of the Independent Commission on Banking (ICB).24

13.14  The ICB, established in April 2011 under the chairmanship of Lord Vickers, was charged to make recommendations for the reform of the UK banking sector, with a view to reducing systemic risk, mitigating moral hazard, and reducing the likelihood and impact of firm failures. The Vickers Commission was also asked to consider competition in the UK banking sector. The implementation of the recommendations of the ICB and of the various policy issues raised were left to be addressed in the Banking Reform Act, namely banking sector structural reforms and issues of professionalism and culture in the sector—matters at the heart of deliberations of the ICB and the Parliamentary Commission on Banking Standards (PCBS), respectively. The ICB reported formally in September 2011. The key findings and recommendations of the two Commissions and the provisions of the resulting Financial Services (Banking Reform) Act are discussed in the following chapter.

C.  The Financial Services Act 2012

13.15  The Financial Services Act 2012 received royal assent on 19 December 2012 and came into effect from 1 April 2013. The Act comprised ten parts and twenty-one schedules and formally amended the Bank of England Act 1998, the Financial Services and Markets Act 2000 (FSMA), and the Banking Act 2009, to give effect to the reforms.

(p. 259) 13.16  Part 1 dealt with specific matters relating to the strategy, revised objectives, structure, procedures, managerial oversight, and reporting requirements within the Bank of England, including a de facto specific responsibility for financial system stability, incorporating the replacement of the FSA with the FCA and the creation of the PRA and the new FPC.

13.17  Part 2 dealt with substantive changes to the Financial Services and Markets Act 2000, comprising a substitution of sections 1 through 18 of FSMA with new provisions dealing with the creation and definition of the FCA and the PRA as joint regulators, defining their respective statutory duties, their consumer and market related objectives, reporting protocols and obligations to the Bank of England and FPC, as well as executive authority and enforcement powers.

13.18  Part 3 dealt with the extension of the FCA and PRA regulatory regime to embrace UK mutual societies, including industrial and prudential societies, building societies, friendly societies, and credit unions.

13.19  Parts 4 to 6 dealt with critical collaboration and cooperation matters between the Bank of England (FPC), the FCA, the PRA and HM Treasury, and the definition of processes to deal with complaints and investigations against the ‘regulators’.

13.20  Part 7 introduced new ‘misleading statements and misleading impressions’ offences, under sections 89 to 95, the scope of which was a partial extension to the existing offences under section 397 of FSMA. However, the misleading impressions offence was made broader than its predecessor in that it included misleading impressions made recklessly in addition to those made intentionally. The statutory defences to the sections 89–95 offences are substantially the same as that set out in the repealed section 397.

13.21  Part 8 dealt with amendments to the Banking Act 2009, with specific changes to the administration of client assets held in trust, the transfer and reversal of securities and shares, and inter-bank payment and clearing systems. These provisions specifically extend and enhance the previous Resolution Regime to systemically sensitive investment banks, bank holding companies, central counterparties, and certain investment group companies.

13.22  Finally, Parts 9 and 10 dealt with miscellaneous and other general provisions relating to transitional arrangements, consumer credit regulation, and the role of financial ombudsman services.

13.23  The enactment of the Financial Services Act 2012 represented a significant change in not only the regulatory structure, but the regulatory approach to supervision and enforcement. The new mantra was for a more holistic and intrusive form of regulation. Whether viewed from the perspective of the prudential thresholds, conduct of business requirements and new product intervention powers, or in light of the enhanced investigatory and enforcement priorities and a focus on individual accountability, the reforms were significant.(p. 260)

Footnotes:

1  HM Treasury, ‘2010 to 2015 Government Policy: Financial Services Regulation’, policy paper (updated 8 May 2015). The ‘Issue’ underlying the 2010–2015 Conservative and Liberal Democrat coalition government policy on post-financial crisis regulatory reform and the mandate for the Financial Services Act 2012.

2  See paras 8.08 to 8.10 and Ch 10.

3  Foreword to HM Treasury, ‘Review of HM Treasury’s management response to the financial crisis’ (March 2012). Indeed, it was acknowledged by HM Treasury that ‘… the financial sector had not been a high profile area of the Treasury’s business for a number of years [and that] there was a small Treasury team working on financial stability in the immediate run-up to the crisis. The Bank had cut back its staffing on financial stability and the FSA was increasingly focused on consumer and competition issues.’

4  Financial Services Authority, ‘The Turner Review: A Regulatory Response to the Global Banking Crisis’ (March 2009). See Ch 8, Section E for a more in-depth discussion of the Turner Review.

5  The Guardian reporting (‘Turner Review: experts’ views’, on 18 March 2009) the views of, for example: John Cridland, now the Director-General of the Confederation of British Industry, who remarked that ‘Turner has come up with targeted proposals that deal with specific failings and risk to the system as a whole, rather than responding to the wider calls for action against banks. His dispassionate, forensic approach has much to recommend it’; Stuart Fraser, the then Chairman of the Policy and Resources Committee at City of London Corporation, who welcomed Turner’s findings, albeit urging caution over the controversial issue of City pay; and Richard Saunders, the then CEO of the Investment Management Association, who commented that ‘the Turner review sets out a clear roadmap for future reform of the system. We need banks which are simpler, more transparent and once again capable of attracting private capital. The last 18 months have been devastating for the economy and for its financial infrastructure. It is encouraging to see the regulator addressing the issues with real intent and commitment to reform.’

6  See G20 Communique, ‘London Summit—Leaders’ Statement’ (2 April 2009), available at <https://www.imf.org/external/np/sec/pr/2009/pdf/g20_040209.pdf>. This unprecedented programme of intervention appears, however, to be insufficient (whether by design or quantum) to counter what is arguably a secondary liquidity-based crisis now re-emerging within the EURO zone banking sector (and, consequentially, among several of the EU Member States themselves).

7  House of Commons, ‘Themes and Trends in Regulatory Reform—Regulatory Reform Committee’, S 21–40, July 2009.

8  HM Government, ‘The Coalition: Our Programme for Government’ (20 May 2010).

9  HM Government, ‘The Coalition: Our Programme for Government’ (20 May 2010) at p 7.

10  HM Government, ‘The Coalition: Our Programme for Government’ (20 May 2010) at p 9.

11  George Osborne MP, speech at the Lord Mayor’s dinner for bankers and merchants of the City of London, Mansion House (16 June 2010).

12  The ‘twin peaks’ model of financial regulation was pioneered in Australia in 1998 (following the recommendations of the Financial System Inquiry to the Australian Treasury) and prescribes a clear demarcation between the ‘market conduct’ and ‘prudential functions’ of regulation. At the time of writing, this approach has been adopted by the Netherlands, Belgium, New Zealand, and the UK, with South Africa transitioning to this model and it having also been considered by the US. See Goodwin, Guo, and Ramsey, ‘Is Australia’s “Twin Peaks” System of Financial Regulation a Model for China?’ CIFR Paper No. 102/2016, for commentary on the ‘twin peaks’ model in the context of China’s financial system and its evolution since the Australian Financial System Inquiry report.

13  As formulated in section 2A(1) Bank of England Act 1998 (as inserted by section 238 Banking Act 2009). In particular, the FPC’s financial stability objective would include improving the resilience of the financial system by identifying and addressing aggregate risks and vulnerabilities across the system and enhancing macro-economic stability by addressing imbalances through the financial system, eg by damping the credit cycle. See, HM Treasury, ‘A New Approach to Financial Regulation: Judgement, Focus and Stability’ (Cm 7874, July 2010) para 2.24.

14  Established in 2013 as the National Crime Agency, a non-ministerial government department.

15  HM Treasury, ‘A New Approach to Financial Regulation: Judgement, Focus and Stability’ (Cm 7874, July 2010).

16  For an explanation of macro-prudential regulation see, HM Treasury, ‘A New Approach to Financial Regulation: Judgement, Focus and Stability’ (Cm 7874, July 2010) para 2.6 and Box 2.A p 10.

17  HM Treasury, ‘A New Approach to Financial Regulation: Judgement, Focus and Stability’ (Cm 7874, July 2010) para 1.15.

18  In light of the UK’s notification to leave the European Union under Article 50(2) of the Treaty on European Union, the PRA will, almost certainly, resign from any representation on the boards of the ESA. While the extent to which the PRA will be able to influence, at all, the policies of the ESAs is, at the time of writing, unknown, it is anticipated that formal ESA representation will be replaced by a form of cooperation agreement that maintains the necessary framework for managing systemic risk across European markets, in which both UK and EU based-business will continue to operate. The impact of the UK leaving the European Union (so called, ‘Brexit’) on the legal and conduct risk in financial markets will be significant enough for a standalone book on the subject. However, the immediate and most salient issues are highlighted in Ch 19.

19  HM Treasury, ‘A New Approach to Financial Regulation: Judgement, Focus and Stability’ (Cm 7874, July 2010) para 1.19. The implementation of the reformed regulatory architecture resulted in the FCA being responsible for not only the conduct of all firms carrying on regulated activities, but for the prudential regulation of those firms not otherwise prudentially regulated by the PRA.

20  An example of this can be found in the enforcement actions against The Co-operative Bank plc by both the PRA and the FCA. Notably, the FCA’s Final Notice to the bank stated the FCA’s decision not to levy a ‘substantial financial penalty’ given the overriding concern (of both authorities) to maintain the safety and soundness of the institution. The PRA’s objectives, in this instance, took precedence over the policy of the FCA to levy a financial penalty for conduct breaches. See FCA Final Notice, ‘Co-operative Bank plc’ (10 August 2015).

21  HM Treasury, ‘A New Approach to Financial Regulation: Judgement, Focus and Stability’ (Cm 7874, July 2010) para 4.7.

22  HM Treasury,‘A New Approach to Financial Regulation: Building a Stronger System’ (Cm 8012, February 2011).

23  HM Treasury, ‘A New Approach to Financial Regulation: The Blueprint for Reform’ (Cm 8083, June 2011).

24  The Independent Commission on Banking was a United Kingdom government inquiry, chaired by John Vickers, looking at structural and related non-structural reforms to the UK banking sector to promote financial stability and competition in the wake of the financial crisis of 2007–08. The Commission, its findings, and subsequent law reform is discussed in Ch 14.