Chapter 1
Modernisation of Financial Regulation
Introduction
In the UK a consolidated system of regulation has been adopted to govern the deregulated markets that emanated from the ābig bangā in the 1980s and developed thereafter. The Financial Services Authority (FSA) acquired responsibility, as a single unified regulator, over the industries that make up the financial system for the purposes of prudential regulation and supervision and conduct of business. The move towards a single regulator has inevitably impacted on the role of the Bank of England (the Bank), with the transfer of bank regulation to the FSA. However, the responsibilities of the FSA and the Bank are interdependent with respect to maintaining financial stability and market confidence, which is a key rationale for regulation. In contrast the US position is more complex. It has a unique regulatory structure with a number of ābankā regulators in addition to securities and insurance regulators. The USA has experienced a number of very significant spates of bank failures that have given rise to a considerable emphasis on bank safety when it comes to dismantling the barriers between banks and other financial services. As a result of this it has adopted a regulatory framework that now allows conglomeration but with the caveat of protecting the interests of banks. This caveat is in no way unique to the USA but the timing of it is something that makes it important to consider in comparison to the UK experience.
The first section of this chapter outlines the link between financial stability and the need for prudential supervision, because no examination of prudential supervision can take place without some outline of the importance of financial stability. It then introduces the role of the Bank as ālender of last resortā (LOLR), a mechanism to maintain financial stability and market confidence in times of crisis, and highlights that bank supervision is necessary to reduce moral hazard that arises from the existence of the LOLR and other safety-net systems, namely deposit insurance. The second section simply outlines the introduction of a formal system of banking and financial services regulation up to the subsequent transfer of those responsibilities to the FSA. It is important to introduce the regulatory experience in the financial services sector because of the synergy between these areas. It highlights that the underlying policy of enhancing efficiency and competitiveness in the banking and financial services industry during the 1980s and onwards led to, for instance, the growth of bank financial conglomerates. In the third section the move towards a single regulator through the enactment of the Bank of England Act 1998 and the Financial Services and Markets Act 2000 (FSMA 2000) is examined. This section also analyses the objectives and principles that underpin the FSMA 2000 and reviews the work of the FSA so far, in particular the realigning of the interests of the industry with those of consumers. A broad look at the responsibilities of the FSA is needed, beyond bank supervision, to shed light on how it deals with regulatory and supervisory issues from the perspective of practitioners and consumers. The fourth section introduces the US experience of financial modernisation, highlighting that the barriers between banks and securities and insurance businesses have been dismantled in such a way as to ensure the safety and soundness of banks. It reviews the present multi-regulator model and the concerns that arise, such as the problems of cooperation and coordination of regulatory and supervisory efforts. Nevertheless, it highlights the fact that regardless of what regulatory structure is in place, the underlying prudential supervision system needs to be sound. Finally, the fifth section will provide some concluding points and comparative observations about the UK and US approach.
Financial Stability
Financial stability is a catch-all phrase referring to a whole host of factors, both positive and negative, that have an impact on the efficiency with which an economy or financial system performs.1 The ambiguous nature of its scope has been the focus of considerable attention in light of the crises that have plagued financial markets around the world.2 The factors that can give rise to financial stability or instability are associated with the macro-economic environment, such as a change in prices or interest rates or exchange rate fluctuations. In addition, stability can be affected by micro-economic factors such as the efficiency with which resources are allocated, ineffective prudential supervision and general imprudence in financial markets and banks or financial institutions.3 These factors can cause a downturn in the economy or undermine market confidence in the eyes of depositors and investors, giving rise in the extreme to a risk of contagion or systemic problems in the banking or financial system.4
The macro-economic and micro-economic factors are not mutually exclusive, but rather interdependent in an economy. Therefore, financial stability can only be ensured through cooperation between the central bank, other safety-net players and bank and financial regulators. Andrew Crockett refers to this as the micro- and macro-prudential aspects of financial stability as it links the stability of the financial system with the importance of sound supervision of financial institutions.5 For Crockett, the macro-prudential aspect refers to ālimiting the costs of distress to the economy at largeā. The micro-prudential aspect, on the other hand, refers to ālimiting the likelihood of failure of individual institutionsā.6 The link between prudential supervision and financial stability is therefore designed to minimise the adverse impact of a bank failure, for example on the efficient running of the economy or the capital markets.
A āpreconditionā to financial stability is the ability of the central bank to assess financial risks in the marketplace accurately, which requires its own unique infrastructure.7 In addition official safety nets are needed, namely LOLR (lender of last resort) and deposit insurance systems. But to mitigate the risks associated with official safety nets, effective regulation and supervision are needed to ensure banking business is undertaken with prudence.8
The Bank of England and Lender of Last Resort
The Bank of England functions at the centre of the UK banking and financial systems in its role of assisting the government with implementing its monetary policy and acting as the LOLR to ensure financial stability.9 This facility is used to avoid a liquidity problem turning into a panic in the banking and financial system by intervening with financial support.10 The Bank could exercise the LOLR function either by open-market operations or by providing loans to the banking system.11 The central bank intervenes in such circumstances to stabilise market confidence and avoid unnecessary bank failures because of temporary liquidity problems.
Francis Baring first expressed the notion of the LOLR in 1797, although Thornton and Bagehot respectively are given recognition for putting forward the rationale of a formal system of financial support.12 Bagehot proposed a restrictive interpretation of the LOLR: according to him it should be made available provided that it is used to avoid panics when banks experience temporary liquidity problems. It is given at a rate to ensure repayment is made expeditiously once the crisis is over; and it should also only be given against good forms of collateral.13 Another important ingredient in providing financial assistance is that the central bank must act decisively and quickly without hesitation, otherwise a panic could be prolonged and could spread into other parts of the financial system which were otherwise unaffected by the original problem.14
The Bank has acted to avert a financial crisis a number of times over its history, for example in 1821 and 1866 with the failures at Overend, Gurney & Co.15 In 1890 the Bank acted with a consortium of banks to rescue Baring Brothers and Company, deemed insolvent as a result of its exposure to a financial crisis in Argentina.16 The Bank put together a rescue package for Barings to prevent a panic in London and other financial centres.
In modern times the secondary banking crisis in 1971 required the Bank to ālaunch the lifeboatā to avert systemic risk in the banking industry.17 This crisis was the result of a number of factors: a lack of formal bank regulation, mismanagement of risks by banks, contraction in lending in the property market and the expansion of inter-bank markets.18 The rescue package involved financial support from not only the Bank but also the clearing banks. In addition to the 1970sā rescue, a āmini-lifeboatā was launched in 1991 because of a perceived systemic risk in the potential failure of a group of small banks.19 The slump in the property market exposed a number of these banks to the threat of collapse because of the increasing number of individuals defaulting on their mortgages. In order to avert this, the Ba...