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International Financial Regulation

7.      FINANCIAL REGULATION AND CONTROL

 

 

Financial markets provide a number of core functions and services without which modern economies could not have been constructed nor operate. In so doing, a large number of specific advantages arise especially through the process of financial intermediation and with the overall consequent increase in the total stock of financial assets and wealth within society. Markets are nevertheless unstable and vulnerable to failure or collapse. Banking markets, in particular, are inherently unstable in light of the separation or dislocation of the deposit and lending function with a ‘maturity’ gap (pr mismatch or transformation gap) arising between the bank’s ability to receive short-term funds (through deposits or inter-bank borrowing) and the pooling and on-lending of these funds on a medium to long-term (5, 10 or 15 year) basis. Crises can then arise where banks fail to manage this maturity transformation effectively or where financial institutions failure to manage the other risks that arise with their particular type of business activity creates or possibly through other human error or abuse.

 

(1)       Financial Regulation and Supervision

 

Financial regulation is concerned with the imposition of a series of obligations on financial institutions to limit the risks they create. These can be imposed under law, secondary legislative provisions, rules, administrative actions or individual regulatory decisions. Supervision is concerned with the monitoring of compliance by institutions with the regulatory obligations imposed or with more general standards of the market conduct.

 

The purpose of financial regulation is to protect the stable and efficient operation of the markets and ultimately limit potential market support and government costs. For this purpose, all relevant risks have to be identified and managed. Financial regulation is principally based on effective internal risk management with a number of core requirements being imposed on firms to ensure that they manage all of the exposures that their activities created. 

 

Regulatory systems are generally based on a series of parallel Authorisation (or licensing), ongoing Supervision and Enforcement (sanction) measures. All financial laws are based on and incorporate each of these sets of provisions. Almost all financial laws impose a ‘general prohibition’ which prohibits the carrying out of the specific activity covered (such as banking, securities and insurance) without an appropriate licence or authorisation.  The license or authorisation is then only available through compliance with the authorisation, supervision and enforcement measures imposed. (This is imposed under s19(1) FSMA in the UK.)

 

Authorisation is conditional on compliance with a number of regulatory obligations with regard to such matters as the suitability of directors, senior managers and staff (fit and properness), effective systems and controls and governance arrangements and minimum solvency or reserves requirements (capital adequacy and liquidity).

 

Supervision is based on regular returns, possible special reports (asked for by the authorities into such matters as the effectiveness of internal control systems) and relations (supervising meetings on a bilateral basis between the banking and authority or on a trilateral basis also including the internal accountants or external auditors).

 

Enforcement can be carried out through the imposition of fines, censure (pubic or private) or withdrawal of individual approval or firm permission and ultimately winding-up or bankruptcy with the authorities having other interim remedies such as power to apply for disclosure, injunctions or restitution orders.  

 

(2)       Regulatory Approach                    

 

A number of different general approaches can be adopted with regard to the type of regulatory system adopted in any particular country.  These have generally been distinguished in terms of either a ‘Functional’ or ‘Institutional’ approach with writers more recently referring to more sophisticated ‘Objectives’ based approach. A number of countries have also adopted a unitary or ‘Single Regulation’ based system with much regulatory attention following the recent crises focusing on the need to adopt a more general ‘Macro-prudential’ based regime.

 

(a)       Functional

 

Under a functional system, the authorities focus on the types of particular financial activities (such as banking, securities trading or insurance) carried on with a separate agency been set up for each.  This was the general approach adopted in the UK and US and other systems following an Angl American model.

 

(b)       Institutional

 

With an institutional regime, the authorities focus primarily on the key institutions involved with a wider range of authorised activities being permitted. This is, for example, the approach adopted on the European Continent which had specifically adopted a ‘Universal Bank’ model, which allows banks to carry on a wide range of financial activities (including banking, securities, corporate finance, asset management  and financial derivatives) under a single license.  This would generally only exclude insurance services which had to be carried out by separate institution although a number of more complex Bancassurance or Bankaffianz groups were developed in the 1990s which combined all of these activities.

 

(c)       Objectives

 

An objectives based system identifies a number of core separate regulatory purposes with a separate agency being established for each. The increasing extended list of possible regulatory objectives to be imposed on authorities has already been referred to Section 6(4)(e) above. This clearly has to be narrowed with a decision taken as to the most important core functions involved. This may, for example, include Prudential regulation, Conduct or consumer protection, Markets, Payment systems, Financial crime and Competition. A narrower model is also sometimes proposed, which would only involve creating a Prudential (or financial regulatory) authority and then a separate Consumer (or conduct) authority. This has been referred to as the ‘Twin Peaks’ approach and followed as part of the most recent restructuring of the regulatory system within the UK.

 

(d)       Single Regulator 

 

With the increasing high degree of integration of financial sectors and markets, the decision was taken in a number of countries, including specifically the UK under the previous Labour Administration, to establish a single unitary system with a single financial authority for all services and markets. This has been referred to as the ‘Single Regulator’ debate. The effect is to create a single authority to oversee all financial markets and services, such as with the FSA in the UK. This is examined in further detail in Section 7(3) below.

 

(e)       Macro-prudential

 

More recent regulatory systems revisions, especially following the recent crises in the markets, have focused on developing a corer central ‘Macro-prudential’ function either within a separate agency or within the central bank. The new system proposed by the Coalition Government in the UK creates a central bank based macro-prudential model with the Financial Policy Committee (FPC) within the Bank.  Financial regulation of all systemically important institutions is to be transferred to the Prudential Regulatory Authority (PRA), which would be set up as a subsidiary of the Bank, and with consumer protection and market supervision been dealt with by the separate Financial Conduct Authority (FCA). This then combines aspects of single prudential regulation (of all different sectors within the PRA) within a larger new central bank based macro-prudential model.

 

 

 

(3)       Regulatory Structure         

 

The integration of financial markets and operation of large complex groups of financial conglomerates has led to the establishment of single integrated regulators in a number of countries. This has been referred to as ‘the Single Regulator’ debate. This is nevertheless not a single debate with three separate sets of issues being involved each of which have to be distinguished:

 

  1.  initial agency or institutional integration (establishing a ‘Single Regulator’);

  2.  corresponding statutory or regulatory harmonisation (with ‘Single Regulation’); and

  3.  the degree of underlying cross-sector financial integration to be permitted (‘Single Markets’).

 

A number of arguments can be developed for and against either a single or multiple regulatory model. These are generally based on such matters as policy grounds (integration, consistency, simplicity, review and development), institutional issues (administrative control, contact and communication, better allocation and use of resources, improved training and enhanced internal and external accountability) and operational matters (efficiency, responsiveness, flexibility, cost and competitiveness). A number of corresponding arguments can nevertheless be developed against each of these arguments generally based on administrative concentration, loss of regulatory (inter-agency) oversight and competition, potential increased regulatory burden and cost and lack of transparency and accountability and abuse more generally.

 

Appropriate corrective mechanisms have then to be adopted in each case. The issue is accordingly not one of whether any specific single or multiple regulator solution is better on a theoretical basis but on the effectiveness of subsequent corrective adjustments adopted after the decision is taken either to adopt a single or multiple model. The single or multiple regulator choice must initially be taken having regard to the local market, economic, legal, regulatory and to some extent political considerations with an appropriate set of corresponding corrective measures or adjustments then being put in place to deal with the corresponding disadvantages that arise depending upon which option is selected.

 

With the more recent changes that have taken place in markets, a general presumption in favour of regulatory integration has arisen rather than the continued use of a multiple regulatory model. A number of factors have tended to favour the move towards an integrated solution. These include:

 

  1. Increased market complexity and high degree of underlying market integration that has taken place in recent years;

  2. The multiple objectives adopted by regulators and new complexity of regulatory models;

  3. Massive demands of complex information collection, processing and exchange in modern markets;

  4. The need for co-ordinated regulatory action and enforcement; and

  5. The need for co-ordinated and extended market support mechanisms in the event of a major crisis.

 

The Coalition Government in the UK has nevertheless decided to adopt a partial ‘Twin Peaks’ with a separate PRA and FCA. This is necessary due to the decision to create a centralised Macro-prudential function with the FCA within the Bank. The Bank will then be responsible for the conduct of monetary, regulatory and macro-prudential policy. It was then necessary to separate supervision of non-systemic institutions and other markets as otherwise the Bank would have been overloaded.  This can then be justified on the basis of non-systemic regulatory delegation of function.

 

(4)       Regulatory Design             

 

A number of common or general issues arise in setting up or designing a regulatory system within all countries. Each of these has to be considered either expressly or implied impliedly in drafting national regulatory laws. The overall effectiveness of any national, regional or international regulatory system will depend upon the extent to which an appropriate set of decisions has been taken with to regard each issue and how well they operate together in practice.

 

(a)       Objectives

 

The authority or authorities must be assigned clear objectives with these being appropriately prioritised or the authority being given necessary discretion to determine how they should be balanced in practice. The principal possible objectives have already been referred to in Section 6(4)(e) and section 7(2)(c) above.

 

(b)       Structure

 

The system must either operate on the basis of a single or multiple agency basis with an appropriate degree of division of function been specified where more than one agency is involved. Whichever model is selected, an appropriate set of oversight and accountability mechanisms must be adopted as discussed in Section 7(3) above. Where a multiple agency system is to be used for other necessary contact, consultation, co-operation, exchange of information and coordination of action procedures must also be set up.

 

(c)       Scope or Tools

 

Regulatory systems can operate at a number of different levels, depending on the degree of active oversight and supervision desired.  Five general options or degrees of intervention can be distinguished with an appropriate mix been selected in any particular case:

 

  1. Full Authorisation or Licensing for all regulated firms or businesses operating on an individual basis;

  2. A Permission requirement for each of the particular financial activities to be carried out;

  3. Individuals may be separately Approved such as with the UK Approved persons regime imposed under s59 FSMA;

(iv)       Stock market and exchanges can be separately Recognised such as under Part  UK FSMA;

  1. Less formal Registration or simple Notification systems without onerous conditions may also be used in areas where a full regulatory system is not considered necessary.

 

A dual Authorisation and Permission regime was set up in the UK under ss19 and 20 FSMA partly as this is a single regulatory system and partly as firms from other EU countries are already pre-authorised under relevant European financial directives. All firms are required authorised under s19 FSMA but with the specific activities that they are entitled to carry on been set out in their separate permission listing under s20 FSMA. European firms are authorised under Schedules 3 and 4 provided that they comply with certain notification requirements and only otherwise have to confirm that they have the necessary permission from their home country failing which they would have to apply to the FSA to have this extended.

 

(d)       Source

 

Regulatory obligations can be imposed through a number of different sources as has already been referred to. A number of overlapping masures are generally adopted in practice in most countries depending upon local practices and traditions.  The principal options are:

 

  1. A financial Law or statute;

  2. Secondary legislation (referred to as the Statutory Instruments in the UK);

  3. Financial rules under a delegated power to the regulatory agency usually supported by a separate power to issue guidance;

  4. Financial principles to impose more general standards of good conduct;

  5. Individual regulatory decisions or administrative actions.

 

The UK regulatory system operates through the statutory FSMA with a large number of separate Statutory Instruments being issued under the FSMA. The core agencies, roles and functions, powers and authority and offences and remedies are dealt with under FSMA. Some important provisions are defined (such as the full list of ‘regulated activities’ and exemptions) with its of coming into force (commencement) and repeals been dealt with through separate statutory instruments. The FSA has issued a separate integrated Handbook of Rules and Guidance under ss138 and 157 FSMA which also includes certain general principles or high level standards such as the 11 Principles for Businesses included within the PRIN section of the Handbook (available http://www.fsa.gov.uk/pages/handbook/ ). The 11 Principles in PRIN impose basic standards of financial institutions with regard to Integrity; Skill, care and diligence; Management and control; Financial prudence; Market conduct; Customers' interests; Communications with clients; Conflicts of interest; Customers: relationships of trust; Clients' assets; Relations with regulators.

 

(e)       Content

 

A number of basic regulatory obligations have to be imposed under the mix of laws, instruments, rules and guidance and principles adopted. These provisions can generally be considered to be made up of a mixture of Financial rules, Conduct rules and Market rules, as well as supplementary Resolution and Support or Oversight rules.

 

                        (i)        Financial Rules

 

Financial entry rules are concerned with controlling the quality of the institutions like to operate in a particular marketplace. As discussed, market entry requirements are essentially based on initial Authorisation (licensing or entry conditions), continuing Supervision (based on the filing and submission of continuing returns, reports and relations (through management and regulatory meetings) as well as special visits and inspections) and Enforcement in the event of breach (including sanction in the form of fine or censure as well as restriction or cancellation of authorisations or other protective measures such as injunctions or freezing orders).

 

The most important initial authorisation and continuing supervisory obligations are based on minimum capital and liquidity requirements the purpose of which is to protect the solvency of the institution from trading losses.  Capital adequacy creates a reserve on the liability side of the balance sheet principally made up of paid-up share capital and retained earnings, as well as other items such as disclosed and underscores reserves, revaluation reserves (property of foreign exchange), general provisions, hybrid capital instruments and minimum five-year subordinated debt. Core tier 1 capital consists of paid-up share capital and retained earnings with tier 1 also including disclosed reserves and all other items falling within tier 2. Banks must maintain under the Basel Committee on Banking Supervision’s Basel I rules a minimum capital to risk adjusted assets ratio of 8% with 4% tier 1 and 4% tier 2 including 2% core tier 1 capital. The Basel Committee had also created three separate Pillars of Standardised charges, Supervisory review and enhanced Market discipline under its Basel II rules in July 2004 which were further strengthened under Basel III in December 2010. The work of the Basel Committee is considered further in Section 9 below.

 

Liquidity rules require banks to hold a certain proportion of items on the asset side of the balance sheet in a highly liquid form generally either consisting of cash or government securities that can be disposed of quickly. While banks generally kept liquid reserves of around 30% historically, this fell to between 1-3% just before the financial crisis, mainly due to the ability of banks to borrow short-term funds on the interbank markets. Liquidity rules have been tightened substantially since with the Basel Committee specifically introducing a new minimum Liquidity Coverage Ratio (LCR) and Net Stable Funding Ratio (NSFR) as part of its Basel III package of measures agreed in December 2010.

(ii)       Conduct Rules

 

Conduct rules are concerned with ensuring that market participants (firms and individuals) operate in accordance with relevant accepted standards. These consist of basic criminal laws (including prohibitions on theft, fraud and insider trading) as well as supporting civil law remedies (such as penalties for market abuse, misrepresentation and statutory damages). More specific ‘conduct of business’ (COB) rules will also be imposed in more complex sectors such as in the securities area where firms have to manage difficult firm/client and inter-client conflicts of interest. The current main UK conduct of business rules are set out in the revised Conduct of Business Sourcebook (COBS) contained in the Financial Services Authority’s (FSA) Handbook of Rules and Guidance as amended by relevant European provision. A separate insurance conduct of business (ICOB) has also been adopted recently.

 

                        (iii)      Market Rules

 

Market rules deal with the structure and operation of specific formal markets. These include provisions in connection with primary debt or share listing, subsequent secondary trading or dealing and the clearing and settlement of trades. Clearing refers to the netting or offsetting of multiple sales and purchases in the same stock during the trading period to produce a net final amount due. Settlement refers to the actual exchange of cash and security on the agreed settlement date which generally takes place within three days of the trade (T+3) under best global practice.

 

                        (iv)      Market Resolution

 

While financial laws initially govern market entry through authorisation, supervision and enforcement (above), they must also deal with the exit of financial institutions from the markets. Market exit rules are concerned with the realisation of assets within a failed institution (generally based on winding up and insolvency laws) and other liabilities or claims resolution (through appropriate complaints, compensation (deposit protection or insurance) and other corrective action powers on behalf of the relevant recovery agent in the event of the firm’s closure and insolvency).

 

 

 

 

A considerable degree of attention has focused on the resolution of banks and other financial institutions following the financial crisis. Special procedures must be in place to deal with financial banks and institutions in difficulty. This can either be achieved through internal Reconstruction and Recovery Plans (RRPS or ‘Living Wills’ in the UK or ‘Funeral Plans’ in the US) or formal resolution powers available to the regulatory authority or separate public entity (referred to as the Special Resolution Regime in the UK or SRR). RRPs can be designed to include capital on liquidity support, additional funds through asset, business or subsidiary disposals or the larger restructuring of an institution including ultimate winding down and closure.

 

Equivalent statutory powers are conferred on the authorities under an SRR which allows them to restructure the institution in the event that the RRP fails. While special powers were available to the Federal Deposit Insurance Corporation (FDIC), few countries maintained necessary formal resolution powers before the global financial crisis and only relied on more general corporate administration or bankruptcy laws. A number of statutes have since been adopted to create effective SRR procedures such as under the Banking Act 2009 UK, which includes a special Bank Administration Procedure (BAP) and amended Bank Insolvency Procedure (BIP) with three SRR options of private acquisition, temporary ‘bridge bank’ transfer or public acquisition (nationalisation).

 

(v)       Market Support and Oversight

 

While all of these financial, conduct, market and resolution rules are designed to ensure that markets operate in an effective and stable manner on a continuing basis, additional reserve, support or corrective mechanisms must also be maintained. Financial regulation can be considered to be involved with limiting risk and exposure within a market with external support also being required when the stability of the market as a whole may be threatened. Compensation for specific financial consumers (bank depositors, security investors and insurance policyholders) is dealt with through some form of deposit protection or insurance which guarantees minimum payments in the event of the collapse of the institution involved. Where the stability of the banking system more generally is threatened, the central bank will provide separate emergency assistance to banks in need of funds. The central bank will then act as a form of ‘lender of last resort’ (LLR) to the banking system. A ‘moral hazard’ danger nevertheless arises in that banks may then take excessive risk in reliance on the emergency funds being available.

 

A series of LLR rules were developed during the 19th century to attempt to deal with this. These were clarified and restated in the writings of the famous economist Walter Bagehot in a collective series of papers published as Lombard Street in 1873 (reissued in 1999 by Wiley Investment Classics). Under Bagehot’s  ‘rules’, emergency funding should only be made available where a bank is experiencing liquidity rather than solvency difficulties with funds only being provided on a penal basis either at high interest rates or on substantial collateral to act as a disincentive to reliance and risk taking (moral hazard). Funding can only be made available to insolvent banks where the collapse of the particular institution may otherwise threaten the stability of financial system through contagion.

 

These traditional LLR rules also generally only apply with regard to banks with emergency funding not officially being made available to securities firms, insurance undertakings or other financial institutions. A reserve facility was nevertheless provided for in the US under the Federal Reserve Act 1913. The authorities have rarely considered using this until the most recent credit crisis during which it was accepted that funds may have to be made available to securities firms. The effect of the integration of financial markets and construction of more complex financial groups has required that traditional LLR rules have had to be reconsidered. It may be that funds are still only made available through banking markets although these can then be redistributed within larger groups and across financial sectors. A number of more specific but still significant extensions to traditional UK LLR practice also occurred following the emergency support provided to Northern Rock by the Bank of England beginning on 14 September 2007.

 

Authorities have also since the global financial crisis developed new Macro-prudential oversight systems to allow them to monitor the financial system and economy as a whole to identify any emerging risks of exposures. Through the specific new institutions have been created with the Financial Services Oversight Council (FSOC) in the US, the European Systemic Risk Board (ESRB) in the EU and Financial Policy Committee (FPC) within the Bank of England in the UK, which replaced the earlier Council for Financial Stability (CFS) set out immediately after the crisis. Each of these bodies is developing new procedures for the collection and examination of market information and data and appropriate tools to deal with emerging threats to the stability of the financial system.

 

(5)       Regulatory Adjustment

 

Modern financial regulation has become considerably more complex in recent years, especially as a result of all of the changes that have taken place in markets and supporting computer and telecommunications technology. This has affected regulatory practice in countries in different ways although a number of more general changes and trends can be identified. These are clearly visible in the UK which has constructed a particularly sophisticated and integrated regulatory model. The following trends can be identified within the new UK regulatory system:

 

  1. The regulatory system has become increasingly ‘risk based’ as regulatory objectives are targeted to secure a large number of key risks or exposures;

  2. The system has become increasingly rules (rather than law or statute) based and then more principles based with consequent improvements in terms of flexibility, speed of adaptation and the promotion of a more generally compliance culture although this has to be balanced against concerns of increased uncertainty, enforceability abuse and consequent legality issues;

  3. The regime has become more clearly objectives based with a number of parallel purposes or targets being pursued at the same time (including financial stability, capability, efficiency, competition, innovation, effectiveness, conduct, crime, ethics and contribution);

  4. The adoption of rules and principles are based on a new ‘Better Regulation’ procedure which includes:

 

  1. Full consultation;

  2. Maximum transparency;

  3. Conduct of a full cost benefit analysis;

  4. Completion of a proper competition analysis; and

  5. Respect for necessity and proportionality.

 

  1. Modern financial regulation had become increasingly market based with a reliance on market solutions as regulators had moved from more traditional regulatory intervention to firm self-assessment and compliance although this has then been tightened again following the global financial crisis as part of the larger re-regulation of financial markets .

 

 

 

 

We are beginning to see the emergence of a new national, regional and international regulatory agenda based on these new trends. There is a new complexity and sophistication in modern financial relations, policy and control which reflects concerns with the need to protect the continuing stability of financial markets within an increasingly single integrated and interdependent global marketplace and limit the costs of crisis and collapse.

 

 

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