The revolution in bank regulation: Turner versus Larosière

United Kingdom

Everyone now recognises:

  • That we need a new regulatory regime to deal with macro-prudential issues and systemic risks; and
  • That in Europe the system of national regulators operating under EU single market legislation does not work.

Before the TSC on Wednesday, Lord Turner recognised that the FSA had failed to deal with systemic issues and pitched for a formal role under the new legislation. He wants the FSA to be an all sectors regulator at systemic, prudential and conduct of business levels.

Meanwhile, the Larosière Group proposed new European authorities for these roles and increased involvement in the regulation of individual banks and insurers. The big issue now is how much power will pass to Europe and what residual role will be left for national authorities such as the FSA.

UK bank and insurer trade bodies have cautiously welcomed Larosière. An increased role for European bodies in prudential regulation, both systemic and of individual firms, has its supporters; there is also support for splitting prudential regulation from conduct of business (which some member states already do). The idea that an all sector European prudential regulator would be matched by an equivalent body for conduct of business and market regulation will be much more difficult to sell.

Moving from national regulators to pan-European authorities?

The European Commission’s expert group chaired by Jacques de Larosière (which included Callum McCarthy, the previous chairman of the FSA) reported on Wednesday (please click here to view the report). It proposes a new European System of Financial Supervision (ESFS). There would be immediate improvement in co-operation between the current authorities, but by 2011/12 there would be three new European authorities (the European Banking Authority, the European Insurance Authority and the European Securities Authority); these would act together with the national banking, insurance and securities regulators (such as the FSA). The new European authorities will replace the current, highly unsatisfactory, groups of national regulators – CESR, CEBS and CEIOPS.

The three new authorities will set regulatory standards and supervise national authorities. This will include prudential approval of pan-European mergers and acquisitions, participation in on-site inspections, aggregating information from cross-border institutions and ensuring consistent prudential supervision. The European Authorities would take over where national regulators disagreed in relation to capital add-ons, internal model approvals and other issues relating to a cross-border institution. They will also be involved in authorisation, supervision and enforcement of some pan-European sectors (such as credit rating agencies and post trade structures).

ESFS will be responsible for micro-prudential supervision; macro-prudential supervision will be the responsibility of a new European Systemic Risk Council (ESRC) chaired by the president of the ECB but including the Bank of England and the European Commission.

The next stage of development outlined in the report involves a potential move to two European authorities – one for bank and insurance prudential supervision and financial stability and the second responsible for conduct of business and market issues; this will be coupled with wider supervisory duties at the EU level. The report does not favour the idea that this move should be restricted to regulation of large cross-border institutions only.

The ABI has recently given some support for the idea of a single pan-European prudential regulator in the insurance sector; its short-term objective no doubt is to achieve adoption of the "group support" regime under Solvency II.

The debate will now start in earnest on how far national regulators should be run down and replaced by these new European authorities.

Solvency II

The Larosière report calls for a resolution of the current dispute over Solvency II (the new solvency regime for EU insurers). In particular it supports the so-called “group support” regime, which UK insurers are keen to see adopted.

Lord Turner’s 18th March Report

Lord Turner, before the Treasury Select Committee on Wednesday, flagged his report due on 18th March as a “revolution” in bank regulation. His critique of the current regime included:

  • The FSA placed too much emphasis on regulating bank’s internal systems, processes, controls and governance. This reflected the regulatory philosophy of the time that commercial and business decisions were a matter for the management of banks and were not to be challenged by regulators. He highlighted a shift within the FSA to analysis and understanding of the fundamental economics of the banks.
  • Much more stringent capital requirements were required; this would reduce the excessive size of banks’ trading books
  • He was doubtful about a strict Glass-Steagall segregation of retail banking and wholesale/investment banking but thought the new regulatory regime would lead to some simpler and more narrowly focused institutions emerging.
  • There was a lack of analysis of systemic risks and a failure to take action to protect financial stability. Both the Bank of England and the FSA claim that there was no legal obligation to perform this role and the issue fell between the two of them. Lord Turner was clearly pitching for the FSA to have a key role in the future. The current FSA objectives in the Financial Services and Markets Act 2000 are muddled in this area, as is the Bank of England's constitution. However, there is increasing recognition that whichever authorities are involved, there needs to be a clear objective to deal with systemic risk and financial stability and this needs to be coupled with the necessary legal powers.