The road to regulatory reform

The UK’s financial services sector has been thrust into the frontline of the political battle over supply side and post-Brexit reforms


During the summer-long Conservative leadership election, many in the City were surprised to hear the successful candidate, the now replaced Liz Truss, talk about the need to reform Solvency II, the decade-old rules inherited from the European Union governing the matching of liabilities and investments of insurance companies. For the then Prime Minister these were symptomatic of the restrictive EU rules that are holding back the UK economy.

This view is shared widely across the sector, with the Association of British Insurers estimating that up to £95bn could be liberated from insurers’ funds to invest in infrastructure and the green recovery if the Solvency II rules are relaxed, especially giving more credit for less liquid long-term assets when matching assets with liabilities. The potential reforms go much further than just a re-jig of the solvency rules for insurers – it is a topic of heated debate in the EU too, where industry and regulators are at loggerheads over similar proposals to relax the current regime.

The role of financial regulators in the UK is also under intense scrutiny. The financial services sector has been pressing for several years for regulators – the Bank of England, the Prudential Regulation Authority and the Financial Conduct Authority – to be given a duty to promote the competitiveness of the sector. This means many different things depending on who you speak to. Most see it as a need to promote the sector against foreign competition, others as a duty to ensure competition within the market, especially by encouraging innovation in areas such as cryptocurrencies. These pleas were already finding a sympathetic ear in government before the abrupt departure of Boris Johnson.

Regulatory reform
The Financial Services and Markets Bill – a wide-ranging package of reforms – published in July contained a commitment to make promoting competitiveness a secondary objective of UK regulators, behind their primary objectives of financial stability and consumer protection. The Chancellor of the Exchequer at the time, Nadhim Zahawi, told a high-level City audience at the traditional Mansion House banquet that this was the right approach.

“We will give the FCA and PRA a new, secondary objective: to facilitate growth and competitiveness. I know that some people will say that making this a secondary objective, doesn’t go far enough. Others will say that having it as an objective at all, goes too far,” Zahawi said.

He argued that this “balanced approach” was the best solution. “But, by making it secondary, we’re giving the regulators an unambiguous hierarchy of objective with financial stability and consumer protection, prioritised,” he continued.

UK Finance, which represents a large part of the banking and finance sector, backed his approach: “We strongly welcome the new secondary objective for competitiveness and growth that the Bill assigns to the FCA and the Prudential Regulation Authority. This will demonstrate that the UK is open for business and will give firms the confidence to invest for the future. A thriving, internationally competitive financial services sector provides hundreds of thousands of high-quality, well-paid jobs, lends to help businesses grow and contributes tax revenue for the public services on which we all rely.”

However, some in the City are now hoping the government will go further and believe the new Chancellor, currently Jeremy Hunt after Kwasi Kwarteng’s brief stint, can be persuaded to make this a primary objective of the regulators. The promise in Kwarteng’s UK growth plan that “the government will bring forward an ambitious deregulatory package to unleash the potential of the UK FS Sector,” has encouraged this view. This was not dampened when the sector lobbied the new Treasury ministers at the recent Conservative Party conference, according to Graeme Trudgill, executive director of the British Insurance Brokers’ Association.

Ministers “appeared to accept our point that the new growth and competitiveness objective on the regulator needs to have more teeth and would be better suited as a ‘primary’ or ‘operational’ objective, not a ‘secondary’ one, which makes it effectively tertiary to their operations,” says Trudgill.

With the new Chancellor still supporting most of the headline supply side reforms, such as the low regulation enterprise zones, the sector is optimistic that the competitiveness objective will remain, although it is still seeking clarity on how the balance will be struck between promoting domestic and international competitiveness.

Separating bank and state
This will not be the only contentious issue the new Bill will raise. There has already been debate around the extent to which regulators can be held accountable to the government. This started with some sabre-rattling about limiting the Bank of England’s independence. While this threat seems to have slipped away, the extent to which the activities of the two main regulators – the PRA and FCA – should be subject to government scrutiny has not.

In the run-up to the publication of the Financial Services & Markets Bill, there was speculation that it would include powers for the Treasury to ‘call in’ decisions of the regulators that it wanted to review. In the end, it was left out but it is by no means clear that this debate is over, as Hunt may be tempted to grant such powers if he feels regulators are not fully on board with his agenda.

This would re-open the debate about the bank’s independence as the key regulators all operate under its remit, warns Professor Sarah Hall from the University of Nottingham: “There is a risk that should ministers be permitted to call in regulatory decisions made by the Bank of England, the position of the bank as an arm’s length regulator would be undermined.

This move risks re-politicising regulation which, in turn, could undermine the attractiveness of the UK as a location for financial services.” There has been talk of even wider changes. During her leadership campaign, Truss floated the idea of sweeping up Prudential Regulation Authority, the Financial Conduct Authority and the Payment Systems Regulator into a single new mega-regulator. Nothing has been said yet to discourage speculation that this is a serious proposition.

What goes around
We have been here before. Not once, but many times as it seems the life span of a financial services regulator nowadays is little more than a decade. The current arrangement with the PRA and FCA as the two lead regulators was only implemented in 2013 after the global financial crisis and the decision to break up the Financial Services Authority – a single regulator. The FSA itself was created in 1997 when the new Labour government decided to reform the fragmented system it inherited. Before that there was the Securities & Investments Board, the Personal Investment Authority and a plethora of other regulatory bodies.

Those who have seen many of these changes from the inside caution against creating another mega-regulator. Mick McAteer, co-director of the Financial Inclusion Centre and a former non-executive director of the FSA, who sat on the committee that oversaw the transition to the current regime, says it would be a retrograde step. “The break-up made sense. It was an impossible task for the FSA to cover everything. It really did make sense to split it up,” McAteer said. He warns that throwing those reforms into reverse now would have “a destabilising effect that would be considerable.”

The EU on bonfire watch
Brexit is one of the key drivers behind the broader supply side reforms, with the government promising a ‘bonfire’ of unwanted EU regulations. This has not gone unnoticed in the European Union. Pan-European regulator The European Insurance and Occupational Pensions Authority (EIOPA) moved with unusual speed and, at the end of July when the Bill was published, issued a consultation paper of its own on the use of governance arrangements in third countries, which is the status the UK now enjoys in relation to the EU.

There has already been debate around the extent to which regulators can be held accountable to the government

EIOPA says it is seeking views on “how to enhance the supervision and monitoring of insurance undertakings’ and intermediaries’ compliance with relevant EU legislation concerning governance arrangements in third countries.” Brexit is top of the list of the reasons why it has launched this consultation, which runs until the end of October: “These issues were initially identified in the context of the discussion on the risks arising from the UK withdrawal from the EU”, says the consultative paper.

And it does not mince its words when it highlights the potential risks it sees if third countries drift too far out of alignment with EU regulations: “These governance arrangements may impair risk management and effective decision making, and have the potential to pose financial, operational and reputational risk and ultimately impair policyholder protection.” What is not clear from the consultative paper is the potential responses EIOPA might adopt if it feels any third country steps too far away from its requirements and whether this could extend beyond the insurance and pensions markets it regulates.

A chance for change
The government will also have to win over the regulators themselves as Sam Woods, Deputy Governor for Prudential Regulation and CEO of the PRA made clear at a recent Bank of England webinar. “Brexit gives us an opportunity to rewrite the insurance regulations we inherited from the EU – and in doing so help drive further investment in the economy. But we need to be clear that this is not a free lunch. If changes simply loosen regulations which were over-cooked by the EU, without tackling other areas where regulations are too weak, then we are putting policyholders at risk”, said Woods.

He made it very clear that the PRA was in no mood to take risks with regulation just to satisfy the impatience of pro-Brexit ministers. “Following Brexit we have a once-in-a-generation opportunity to re-shape insurance regulation to work better for the UK. We can do this while loosening parts of the regime which were over-calibrated by the EU and making it easier for insurers to invest in a wider range of assets, but we also need to strengthen it … in order to avoid risks to the millions of current and future pensioners who rely on insurers for their retirement income. The combined effect of these changes should support the government’s objectives for competitiveness, growth and investment in the economy.”

The turmoil on the financial markets following Kwarteng’s ill-fated September 23 mini-budget, which forced the Bank of England to step in to stabilise bond markets because of the threat to pension funds, will reinforce the Bank’s determination not to be forced into what it sees as risky regulatory changes.
Reform is in the air but it is by no means clear how it will conclude.