Proposed legislation that will fundamentally reform the structure of financial services regulation was introduced into Parliament on 27th January 2012.
Although some amendments have been made to the June 2011 draft, the main provisions of the Financial Services Bill remain broadly unchanged.
At the heart of the new regulatory structure will be the Bank of England, which will be the sole authority responsible for preserving financial stability. Within the Bank, a Financial Policy Committee (FPC) will be responsible for tackling systemic risks to the UK economy.
Under the new regime, all banks, building societies and credit unions, investment banks and insurers will be prudentially regulated by the Prudential Regulation Authority (PRA), while conduct regulation will be the preserve of the Financial Conduct Authority (FCA).
The Bill also confirms that the PRA will have a specific insurance objective when it takes over as prudential regulator: "contributing to the securing of an appropriate degree of protection for those who are or may become policyholders".
Most of the changes will take effect as amendments to the Financial Services and Markets Act 2000 (FSMA) rather than by repeal and re-enactment of existing legislation. In this way, the Government hopes to keep to its tight timetable of getting the Bill passed by the end of 2012 and implemented in early 2013.
In the meantime, Hector Sants, FSA Chief Executive has confirmed that, as from 2nd April 2012, the FSA will be adopting the "twin peaks" model within its own structure: a prudential supervisory group to reflect the future PRA and a conduct supervisory group to reflect the future FCA.
A policy statement (126-page / 959KB PDF), also published in 27th January 2012, includes the Government's formal responses to reports on the draft Bill produced by the Parliamentary Joint Committee and the Treasury Select Committee.
The PRA's broader strategic objective will be to contribute to the promotion of stability in the UK financial system and, operationally, to promote the safety and soundness of PRA-authorised persons. The Bill specifies that the PRA must issue guidance setting out how it will interpret this in relation to different types of firms or regulated activity.
The final text also includes a specific "duty to supervise", which was one of the suggestions made by the Joint Committee in order to ensure the PRA takes a judgement-led approach that goes beyond making rules and monitoring compliance.
The insurance objective ("contributing to the securing of an appropriate degree of protection for those who are or may become policyholders") received strong support from respondents to the June consultation.
The Bill goes on to explain that, in relation to with-profits policies, the PRA's insurance objective includes securing an appropriate degree of protection in relation to decisions by insurers relating to the making of payments under with-profits policies at the discretion of the insurer. In this, it will be assisted by information and advice from the FCA.
It is estimated that about half of the firms under the PRA's remit will be insurers. This includes 636 general insurers (of which around 300 operate in the UK under a passport from other EEA countries), 123 life insurers (of which 70 will be EEA-authorised), 133 friendly societies and around 132 insurers involved in the London market.
A joint Bank of England and FSA paper (26-page / 151KB PDF) published in June 2011 explains the PRA's approach to insurance supervision in more detail.
Its role will be "to ensure there is a reasonably high probability that an insurer is able to meet claims from, and material obligations to, policyholders as they fall due. And to make sure that where an insurer is unable to meet such claims and obligations, the adverse consequences for policyholders are minimised by ensuring that the insurer fails in an orderly manner."
In practice, much of this will be achieved by the application of Solvency II, the European-wide prudential framework now due to come into effect at the beginning of 2014. In addition, however, the PRA will be looking to see how firms are run and whether, under their governance arrangements, management are making informed and forward-looking assessments of financial strength.
"The nature of insurers’ business models exposes them to a different set of risks than banks," the PRA paper explains.
"It also means they fail in different ways compared with banks, usually for different reasons and with different impact on the stability of the system. Recognising the particular nature of insurance contracts and insurers’ business models, the PRA’s supervision of insurers will be framed in a different way to its supervision of banks."
The potential risk impact of different insurance business models varies widely, from "traditional" insurance activities, which are likely to have limited impact, to more complex set-ups, such as financial reinsurance or where insurance is combined with banking or other non-insurance activities.
"The nature and intensity of the PRA’s supervisory approach will be commensurate with the level of risk a firm poses to policyholders and to the stability of the system," the paper states.
"Reflecting this, supervision will be tailored to different firms and sectors: it will not be driven by a one-size-fits-all approach but will vary according to risk."
The PRA will base its approach on the principle that all insurers operating in the United Kingdom should be subject to equivalent prudential requirements.
In the case of UK subsidiaries of overseas insurers, PRA supervision will mirror that for UK insurers. But it will have only limited prudential powers over branches of EEA insurers operating in the UK. In such cases, the most it can do is seek to influence the supervisory approach of the home state regulator.
In relation to UK branches of non-EEA insurers, the PRA's powers will also be somewhat limited. It will concentrate on capital and governance requirements and information sharing. The PRA paper suggests it "may also seek to require firms to ring-fence capital".
The FCA's strategic objective has been revised as a result of the consultation exercise. Instead of "protecting and enhancing confidence in the UK financial system", it will be charged with "ensuring that the relevant markets function well".
Operationally, it will be securing an appropriate degree of protection for consumers, protecting and enhancing the integrity of the UK financial system and promoting effective competition in the interests of consumers.
In addition: "The FCA must, so far as is compatible with acting in a way which advances the consumer protection objective or the integrity objective, discharge its general functions in a way which promotes effective competition in the interests of consumers."
The Government hopes this explicit competition mandate will result in the FCA using existing regulatory tools more quickly and effectively to address competition issues, such as the problems that have arisen recently over payment protection insurance (PPI) selling.
For the vast majority of financial services firms - including insurance brokers and intermediaries - the FCA will be their sole prudential and conduct of business regulator.
But the FCA will also regulate the conduct of those firms that are prudentially regulated by the PRA. Groups containing both dual-regulated and FCA-regulated firms are likely to be affected as if they were dual-regulated. Lloyd's (the Society of Lloyd’s and Lloyd’s managing agents) will also be dual-regulated.
In the case of mutuals, responsibility for building societies, credit unions, friendly societies, and industrial and provident societies sector currently lies with the FSA under separate legislation from FSMA. These responsibilities will be transferred to the PRA and the FCA by amendment to the legislation The Government plans to publish a consultation paper later in 2012 asking for views on the appropriate division of responsibilities between the two authorities.
In its June 2011 paper on the role of the new regulator (52-page / 394KB PDF), the FSA confirmed that the FCA will intervene earlier to tackle potential risks to consumers and market integrity before they crystallise, and be "tougher and bolder" in building on and enhancing the FSA’s strategy of credible deterrence.
"The FCA will aim to shift the balance towards tackling the root causes of problems, not just the symptoms," the paper stated. "This will involve analysis of often complex chains of interaction. It could include reaching up the distribution chain, where appropriate, to intervene in wholesale activity where this could be the source of significant retail detriment."
In some cases, a more proactive approach will mean using existing powers more effectively, such as mandating minimum product standards or restricting the sale of a product to a certain class of consumer. But the Bill gives the new regulator power to intervene in (and even ban) a product for up to a year with immediate effect.
This would an extreme measure, triggered only by certain circumstances and in response to specific market failures. The FCA is to consult on and publish a statement of policy governing the circumstances when it will exercise the power and the factors that it will generally consider before doing so.
In addition, the Bill gives a range of designated organisations, including the Financial Ombudsman Service (FOS), the ability to bring issues causing significant detriment formally to the FCA's attention. Once an issue has been raised, the FCA would have to announce whether it is causing mass detriment and, if so, what action it proposes to take.
The Joint Committee, however, considered this proposal was not broad enough. In response, the Government has added a provision enabling designated consumer bodies to make “super-complaints” to the FCA as well as to the Office of Fair Trading and require a response within 90 days.
The FCA will also have a range of powers it can exercise were mass detriment is already occurring, such as issuing new rules or guidance or using its powers under section 404 of the Financial Services and Markets Act (FSMA) to set up an industry-wide redress scheme, or the adoption of a single-firm redress scheme.
Other measures in the Bill include enabling the FCA to publish the fact that it has directed a firm to withdraw a misleading financial promotion, and a discretion to make warning notices public.
Warning notices are the first step in enforcement proceedings. Although the FCA would be required to consider the impact of disclosure on those involved, many industry respondents remained concerned at the significant reputational damage publication could cause. The Joint Committee, on the other hand, wanted to remove a provision that required the regulator to consult the firm before disclosure.
The Government, however, is satisfied that the safeguards set out in its June 2011 white paper strike the right balance.
Consequently, the FCA will be required to tell the firm it intends to publish the information and consider any representations the firm may make before doing so. It will publish only such information it considers appropriate. Publication may, for example, note that the firm is co-operating with the regulator or include a fair summary of its representations where it opposes the FCA's actions.
The Government's white paper acknowledged that "effective coordination between the PRA and FCA will be a vital part of the new framework".
The two authorities will have a statutory duty to coordinate the exercise of their functions and an obligation to prepare a memorandum of understanding (MOU) on how they will work together. The Government wants to see them develop a “collaborative culture”, but the PRA will have an ultimate veto over actions proposed by the FCA that might threaten financial stability or risk the disorderly failure of a firm.
Additional mechanisms will ensure that the PRA and FCA are held accountable for how effectively they coordinate. The MOU will be reviewed annually and laid before Parliament and both regulators will be required to include in their annual reports an account of how they have complied with the statutory duty to coordinate their actions over the year.
These cooperation arrangements will have particular significance in the case of with-profits policies. The Bill explains that, as part of its insurance objective, the PRA's role includes securing an appropriate degree of protection in relation to decisions by insurers relating to the making of payments under with-profits policies at the discretion of the insurer.
Since such considerations include a significant element of consumer protection, however, the PRA will need to be assisted by information and advice from the FCA.
There has been some discussion about how the authorisation process would work in dual-regulated firms.
The original proposal was that individuals who exert significant influence over their firm, or who carry out customer-facing functions, would have to satisfy both the PRA and the FCA that they are fit and proper persons to undertake controlled functions. The June 2011 white paper, however, proposed that the PRA would have primary responsibility but the FCA would be able to designate SIFs in areas where the PRA has not done so.
Following the consultation exercise, the Bill now provides that the FCA must give its consent over the approval of key individuals conducting SIFs in dual-regulated firms.
But the Government is concerned to ensure that the involvement of both regulators does not lead to a cumbersome approvals process, so there will be a single administrative process, details of which will be set out in the MOU.
Dual regulation will also affect transfers of insurance business under Part VII of FSMA. The PRA as prudential regulator will have primary responsibility for the transfer process, but the FCA will also need to be satisfied that the transfer will not adversely affect the customers of the firms involved. The ultimate decision whether or not to approve the transfer will, of course, remain with the court.
In addition, both the PRA and the FCA will be able to initiate insolvency proceedings against an authorised firm, although they must notify the other if they are planning such a move. In dual-regulated firms where the FCA is proposing to begin insolvency proceedings, or where the firm is in a PRA-regulated group, the FCA will have to obtain the PRA's prior consent. This is an area where the PRA's veto may come into effect if the PRA considers the FCA's action risks a disorderly failure of the firm.
Following recommendations made by the Joint Committee, the Bill now includes a single, independent complaints system covering the PRA and the FCA. The policy paper states:
"This reflects the Government’s commitment to openness and transparency for the new regulators, and will ensure consistent investigation of complaints involving both regulators - including, as highlighted by the Joint Committee, possible complaints about the coordination arrangements between the FCA and PRA. This arrangement is also likely to be more cost effective than establishing and running two separate complaint systems.
"The external complaints scheme will also cover the Bank of England’s regulatory functions in relation to recognised clearing houses and payment systems."
The Bill includes provisions to formalise the co‑operation between the Financial Ombudsman Service (FOS) and the FCA which will enable the FCA to use the FOS as a source of intelligence and information. The FOS will, however, remain operationally independent.
Each regulator will have rule-making powers over the Financial Services Compensation Scheme (FSCS). The PRA will be responsible for making rules about compensation, fees and levies on deposits and insurance provision. The FCA will make the rules relating to all other types of financial activity covered by the scheme.
Responsibility for taking regulatory action to counter financial crime will transfer from the FSA to the FCA.
The Government is aiming to have the Bill passed by the end of 2012 and the new framework implemented in early 2013. In preparation, the FSA will be operating a "twin peaks" model within its own structure from April 2012 to reflect the upcoming division between prudential and conduct supervision.