04 October 2012

FSA/Bailey: Prudential regulation - Challenges for the future

Bailey emphasised that the current package of reforms was not about "dragging the rest of the financial services industry into reform to solve a problem that is in essence only about the banks". A system must be designed that works effectively for all sectors of the industry.

For both banks and insurance companies, the PRA will have the objective of promoting the safety and soundness of firms. Consistent with this objective, it will focus on the potential harm that firms can cause to the stability of the financial system in the UK... For insurance companies, the PRA will have the second objective of contributing to securing an appropriate degree of protection for policyholders. 

There are a number of important points in this description of the PRA’s objectives. First, the emphasis on economic well-being as an ultimate goal aligns the supervision of banks and insurers more closely to the field of macro-economic policy. This is in line with the definition of ‘financial stability’ as the continuity of supply of critical financial services which are important to the functioning of the economy. Three services stand out here: the provision of payment services including access to funds; credit extension; and, risk transfer.

The second important point regarding the meaning of the PRA’s objectives is that it will not be the PRA’s role to ensure that no firm fails. Rather, the PRA will seek to ensure that any firm it regulates that does fail should do so in a way that avoids significant disruption to the supply of critical financial services.

The challenge of resolving PRA-regulated firms goes beyond banks. Insurers raise exactly the same issue of continuity of provision of critical financial services. Moreover, in a line of business such as with-profits life, the business model involves pooling many vintages of long-term contracts in a single fund for the benefit of policyholders.

Achieving the objective of avoiding a no failure regime requires a fundamental change of mindset both inside the PRA and in society more broadly. Fear of failure is an important conditioner of behaviour in a financial regulator, and achieving a change on this front depends on establishing a wide acceptance of the approach that orderly failure that does not compromise public policy objectives is an acceptable outcome. If failure is orderly, and does not compromise public policy objectives, the responsibility should rest with the board and management for failing to serve the private interest of their shareholders and creditors.

At present the FPC is pursuing two important objectives: seeking to increase the resilience of the UK banking system, including to the threats emanating from the euro areas; and, subject to being content with the path towards greater resilience, supporting the creation of credit in the UK economy. 

There is one further element to the package of reforms, namely the measures proposed by the Commission chaired by Sir John Vickers, which the government intends to place into legislation in the near future. The key plank of this is to ring-fence commercial from investment banking and, in doing so, define the scope of commercial banking that can be inside the ring-fence. This will be a major structural change for the banking system, and will have important implications for us as regulators.

Bailey concluded: "We will get a much clearer focus from splitting prudential and conduct regulation for banks and insurers, from introducing macro-prudential regulation to help to protect the financial system as a whole, and from focusing our regulation on applying judgement in a transparent way. Firms that mess up should, and will, be allowed to fail, but it must not be at the cost of damaging the financial system and economy. Ringfencing commercial and investment banking will help to achieve that objective. And, out of these reforms I hope we can encourage a banking system that is more open to competition and serves the public more effectively and, more broadly, a financial system that delivers the public policy objective of financial stability."

Full speech

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