Earlier this month, the Bank of England and Financial Services Act 2016 was given Royal Assent and thereby confirmed the UK Government’s latest financial regulatory reforms into law. The Act contains a range of legislative provisions for the UK regulatory framework. At the heart of these reforms are measures to provide the Bank of England with the authority and tools to oversee and ensure financial stability in the UK and implement Governor Mark Carney’s ‘One Bank’ reforms to broaden its range of responsibilities.
This Act also represents the third major piece of legislation overseen by Chancellor George Osborne since 2010 designed to provide greater resilience of the financial system following the financial crisis. It follows the Financial Services Act 2012 (which abolished the previous ‘tripartite’ system of financial regulation) and the Banking Reform Act 2013 (which mandated structural reforms on banks, including ring-fencing). Given the volume and pace of regulatory change experienced by the financial services sector in recent years, there will be many wondering if these latest measures are (a) necessary and (b) effective in ensuring financial stability. These measures also concentrate a significant amount of power and responsibility within one institution. It therefore significantly raises the importance of issues around accountability and governance of the Bank, as well as its relationship with government and its role in broader areas of economic policy.
In order to better understand the potential impact of these changes, it is worth conducting a close examination of the Act’s key provisions, their likely consequences and the challenges that remain in terms of financial stability and supporting economic growth.
Reconciling macro and micro-prudential regulation
One of the key features of the Act was its ending of the subsidiary of the Prudential Regulation Authority (PRA) by bringing in micro-prudential regulation of financial institutions into the scope of the Bank of England through the establishment of a new Prudential Regulation Committee. This, by on large, should be a welcome development. Combining the responsibilities of micro-prudential supervision with macro-prudential policy within one institution should lead to more streamlined and coordinated regulation. It allows the Bank to use prudential policy for macroeconomic ends and proactively address risks related to features of financial institutions and markets. It removes any tension that previously existed between the Bank of England and PRA (and previously the FSA) which led to the Bank ‘second guessing’ the capital and liquidity requirements for individual financial institutions (and sometimes increasing them).
This new arrangement should provide greater clarity for firms, on the prudential front, although tension will remain with regards to the competing supervisory priorities of the Bank and the Financial Conduct Authority (FCA) in regulating firms. While there is a degree of coordination between the two regulators (the FCA has a seat on the Bank’s Financial Policy Committee), the Bank has sometimes regarded the FCA’s conduct oversight as too intrusive. Indeed, it has been speculated that it was the overly intrusive nature of the FCA’s thematic work, conducted under the previous CEO, Martin Wheatley, which ultimately led to Chancellor George Osborne dismissing Wheatley and replacing him with Andrew Bailey as CEO. Given Andrew Bailey’s experience in the Bank of England and reputation for steady even-handedness, the Chancellor’s intention would appear to be to ‘rein in’ the FCA and ensure it is fully in sync with the Bank.
This does raise questions about the operational independence of the FCA and about how seriously the government regards financial conduct regulation. If one were to be a cynic, one could argue that the Chancellor may as well have integrated the entire FSA into the Bank and simply had one financial regulator! Indeed, there would have been advantages in him doing so – when assessing the sustainability of business models, there needs to be a consideration of both conduct (suitability) and prudential (balance sheet capacity, liquidity and capital). Moreover, conduct risks can have ramifications on the safety and soundness of banks. These issues can be addressed on the Financial Policy Committee but financial firms are generally supervised by two sets of supervisors, imposing both substantial public cost as well as time.
From a systemic policy point of view, however, the reconciliation of macro and micro-prudential regulation policy does enable the Bank of England to support its position as a central bank. By combining its position as lender of last resort with its prudential role of ensuring the safety and soundness of individual financial institutions, the Bank is better equipped to adopt Walter Bagehot’s principle that central banks should lend freely against good collateral at penalty rates in times of crisis – ensuring financial stability and delivering public good.
An Expanded Remit: ‘One Mission, One Bank’
As well as bringing prudential policy into the Bank’s expanded remit, the Act provides a number of measures which cements the Bank’s position at the centre of UK’s financial regulatory regime. The changes to the statutory basis of the Financial Policy Committee (first established in 2011) will mean that the setting of the Bank’s financial stability strategy is transferred from the Court of Directors to the Bank itself. This will put the Financial Policy Committee in line with the Bank’s Monetary Policy Committee and the new Prudential Regulation Committee and will help harmonise the conflicts around monetary policy and financial stability.
At one level, this is a sensible move to ensure the institution can operate more effectively in carrying out its aims of overseeing monetary policy, financial stability and supporting the economic policy of the government. It means, however, that the Bank and its Governor assume an even greater level of responsibility for the wellbeing of the UK economy, for which it must be held accountable. It also raises questions about the Bank’s relationship with the Government and its role in other areas of economic policy that impact on financial stability, for example on fiscal policy. However, there is an argument that the Bank should take a more proactive view on wider areas which impact on financial stability, but there is also a concern that the Bank should not get too political or involve itself in issues which are the matter of a democratically elected Government. This concern was evident recently when Governor Mark Carney spoke out publicly about the dangers of Brexit. The debate about the political role of the Bank of England is likely to continue in future, particularly with its new expanded remit.
A New Role in Resolution and Recovery
The Act confirms procedures around resolution planning for financial institutions and updates arrangements between the Bank and HM Treasury in respect of the crisis management of institutions in distress. These measures were needed to reflect recent changes in the UK and global regulatory regime for global systemically important banks, such as the introduction of bail-in (legislated for in the UK by the Banking Reform Act 2013) and the new minimum standards for total loss absorbing capacity (TLAC) set by the FSB. These requirements have seen the emergence of CoCos (debt instruments that are converted into equity in case of resolution) which are often viewed by markets as extremely risky and volatile.
TLAC has been designed to reduce systemic risk and protect taxpayers and the wider economy from bank failures, but places significant levels of pressure onto the Bank as to how and when it applies the ‘trigger’ for financial institutions in crisis. The Bank’s Proactive Intervention Framework (PIF) is designed to help it consider a financial firm’s proximity to failure and identify and respond to emerging risks at an early stage, but questions remain about the Bank’s procedures during times of high market volatility. This is why procedures around resolution must be constantly reviewed and updated.
While many advocates believe that this new regulatory architecture does not fully eliminate the “too big to fail syndrome”, the introduction of TLAC, bail-in and the deployment of PIF does increase the probability that a ‘fat tail’ can be eliminated from financial shocks.
In summary, many of the reforms contained in the Government’s latest legislation are welcome developments, although some important questions remain. How can we be sure that these regulatory measures are effective in ensuring financial stability? Unfortunately we will, of course, have to wait for the next financial crisis to test the robustness of this new regulatory architecture – just as the previous ‘tripartite system’ developed by Gordon Brown was tested and ultimately found to be lacking in effectiveness and governance. Under the new system, the Bank of England is more powerful regulator than ever before. So questions about its accountability and governance are likely to be an important part of public debate going forward.