A. Introduction

55. The evolution of the U.K.’s financial markets during the last decade, concerns with consumer protection, and popular perception of weakness in supervision after a number of financial scandals since the early-1990s, led the U.K. government to establish a new framework for financial regulation in the Summer of 1998, with legislation to be completed over the course of the next two years. The new regulatory framework takes stock of the supervisory experience of industrial countries during the last decade and incorporates many innovations that are likely to enhance the stability of the U.K.’s financial system with respect to the pre-reform regime. It will also improve the focus and transparency of both monetary policy and financial supervision. Greater transparency of supervisory practices, greater accountability of supervisors, and strong emphasis on consumer protection are the major achievements of the new framework. The new framework emphasizes the need to consolidate supervisory responsibilities to overcome the fragmented structure of the pre-existing regime and the progressive undermining of traditional barriers between different financial activities, and emphasizes the shift to a single regulator of financial markets—the Financial Services Authority (FSA)—as the best response to this evolution.

56. This paper reviews the regulatory framework being established in the U.K. with the creation of the FSA, and discusses its main features in light of the challenges posed by regulation of a developed and internationally integrated financial system such as the U.K.’s.

B. The FSA’s Main Regulatory Responsibilities

57. The Financial Services Authority (FSA) came into existence on October 28, 1997, as the prospective single regulator for all U.K. financial markets. It replaced the Securities and Investments Board (SIB), following Chancellor Brown’s May 20, 1997 announcement that a single entity would be created, to merge responsibilities for financial supervision previously dispersed among nine regulatory bodies.²⁰ Under the Bank of England Act 1998, which came into force on June 1, 1998, the FSA took over banking supervision responsibilities from the Bank of England (BoE), an action which involved the transfer of about 500 supervisory staff from the BoE to the FSA. At the same time, the FSA also took over most of the staff of the three Self-Regulating Organizations (SROs), and began to supply regulatory services under contract to these bodies, whose Boards will retain legal responsibility for investment business supervision until their eventual abolishment. Pending approval of the legislation supporting the regulatory reform, the remaining staff of the SROs and of the other regulatory bodies are also being transferred to the FSA.²¹

58. The FSA is a private company, with assigned statutory powers, financed by levies on the financial services industry. Its Board is appointed by the Chancellor of the Exchequer and currently consists of an executive Chairman, two Managing Directors, nine non-executive Directors, and the Deputy Governor (Financial Stability) of the Bank of England. The primary objectives of the FSA in its role as financial services supervisor is to promote the safety and soundness of U.K. financial businesses and to strengthen the protection of investors.²² The basic principle under which the FSA operates is that financial businesses’ inability to service their obligations should be made a remote—but not impossible—event. The linchpin of this mandate is represented by a system of authorizations, allowing no one to engage in professional provision of financial services in the U.K. without authorization by the FSA.

59. To be (and remain) authorized, financial services firms must satisfy a set of requirements, including that the business be properly equipped to carry out financial activity and that it satisfies prudential capital requirements. Details of these requirements will be spelled out in the FSA’s Handbook However, the existing and proposed body of legislation, as well as past supervisory practice, provide a clear picture of the regulatory structure to prevail after re-drafting and final approval of the Financial Services and Markets Bill.

60. The FSA’s first check on authorized firms will be at their entrance point. To become authorized, a firm must convince the FSA that it is “fit and proper” to perform its business and to have a realistic business plan and adequate “systems and controls.” The FSA has published its preliminary interpretation of these terms (see FSA, 1998d). The language of existing and proposed legislation, with its emphasis on “integrity,” “prudence,” and “fairness,” on the part of businesses’ management is rather vague. This is intentionally so, however, in keeping with the tradition of existing Acts, and to satisfy regulators’ need for discretion when assessing the opportunity to deny or revoke a licence in contingencies that are too difficult to define in detail a priori.

61. Prudential supervision of authorized institutions is to be carried out by the FSA in accordance with a number of EU directives in the area of financial services, all of which have been implemented in the U.K. Most recently, the EU’s Capital Adequacy Directive (CAD) and CAD II (implemented in the U.K. on January 1, 1996, and on September 30, 1998, respectively) have extended the U.K. supervisory picture to cover market risk and have provided scope for internal value-at-risk (VaR) models to determine risk capital.²³ Importantly, U.K. regulators retain significant flexibility with respect to these and other internationally agreed standards. For instance, they typically set capital ratios above the Basle Accord guideline of a minimum of 8 percent; they also set required capital ratios in firm-specific fashion, taking into account credit and market risk factors specific to a firm’s business, and apply them on a consolidated basis to all financial firms within a group. Prudential requirements for authorized firms also involve limits on maximum exposure toward single (or related groups of) counter-parties; liquidity requirements, aimed at securing an institution’s access to enough cash and high-quality near-cash assets to meet its obligations; and provisioning for ‘bad’ and ‘doubtful’ debts. To ensure compliance with FSA requirements, each authorized firm employs accountants to report periodically on the firm’s operations, on its adherence to the FSA’s guidelines, and on potentially worrying financial developments, such as sharp changes in the firm’s exposure to individual sectors or countries. Teams of FSA staff and professional auditors also review periodically authorized firms’ operations to monitor compliance.

62. The FSA is also responsible for supervising authorized firms’ ongoing dealing with investors; for facilitating the resolution of complaints against authorized firms; for dealing with violations of the rules, including possible imposition of fines and revoking of authorization; and for pursuing market abuses and criminal activities, to the point of possibly seeking criminal proceedings against offenders.

63. This regulatory regime will encompass a wide variety of financial services firms. First, it will apply to about 350 of the over 600 banks authorized to collect deposits in the U.K.²⁴ It will also apply to about 6,300 investment businesses (currently under formal control of the SROs) and to about 16,000 firms whose main activity is not business investment, but have some minor involvement therein (currently regulated by the eight “Recognized Professional Bodies”²⁵). The FSA will also supervise: the six recognized investment exchanges (the London Stock Exchange, Tradepoint Stock Exchange, the London International Financial Futures and Options Exchange, the London Securities and Derivatives Exchange Ltd., the International Petroleum Exchange of London Ltd., and the London Metal Exchange); the two recognized clearing houses, the London Clearing House and CrestCo., which organize the settlement of transactions on the recognized investment exchanges; and ECHO, the clearing house for foreign exchange spot and forward contracts.²⁶ The FSA will also supervise wholesale markets in over-the-counter derivatives,²⁷ and the insurance market, responsibility for which is being transferred from the Insurance Directorate of HM Treasury, along with new expanded powers with respect to Lloyd’s.^28,29 The supervisory role of the FSA as regards foreign currency and bullion remains to be clarified.

64. Finally, the FSA will establish a new single Financial Services Ombudsman to receive and handle consumer complaints. It will also merge the existing five compensation schemes into a new, single compensation scheme, the Financial Services and Markets Compensation Scheme, whose aim is to partially safeguard consumers of financial services against failure of authorized institutions to deliver on their obligations. The FSA will be in charge of appointing the scheme’s Board, for writing its operating rules, and for annually reviewing its operations.³⁰ Day-to-day handling of claims will be the responsibility of the scheme itself, however, which will be set up as a separate company. Like the schemes it replaces, the new compensation scheme will be funded by fees paid by authorized firms and by recoveries from firms in default. These fees will be determined based on “pay as you go” principles and the scheme will be free of cost for investors. The scheme will pay valid claims in full up to a fixed amount, completely phasing out payments above another higher amount.³¹

65. Altogether, this is a formidable range of regulatory and supervisory tasks—encompassing activities responsible for about seven percent of the U.K.’s economy, employing over one million people, and providing essential services to virtually every U.K. citizen. Hence, it is unsurprising that this concentration of power into the hands of a single institution has raised concern in the U.K. public debate. The effort made by the U.K. government to allay these concerns by implementing a set of checks on the FSA’s activities is discussed below, along with a number of other issues brought into the public policy focus by the ongoing regulatory reform.

C. Establishing a Single Regulator of U.K. Financial Markets

66. Without doubt, the aspect of the ongoing U.K. regulatory reform that has attracted the most widespread interest is the integration of financial supervision into the hands of a single regulator. Observers have focused on the prudential grounds for unifying the regulatory framework of disparate economic activities such as traditional retail banking, insurance, and securities investment; have questioned the political viability of attributing an enormous regulatory and supervisory power to a single institution; and have laid stress on the difficulty posed by the separation of the lender-of-last-resort (LOLR) and the banking supervision mandates, following the attribution of the latter to the FSA.

67. There are, of course, grounds for arguing in favor of consolidated prudential supervision of multi-functional financial groups. To the extent that a single holding company manages the risks it takes over different financial activities (say, traditional retail banking and securities-trading) in a centralized fashion; and to the extent that risks taken across different lines of business are not perfectly correlated, then more efficient capital requirements can be set by taking into account correlations among risks with respect to the traditional building-block methodology.³²

68. Efficiency gains in managing global (or “complex,” to use the words of the FSA) groups, are an important goal of the U.K. reform and are further discussed below. However, a discussion of the tradeoffs faced by the U.K. government when it re-designed the domestic regulatory landscape must start from the recognition of the singular need for transparency and accountability that the U.K. government faced after a series of incidents in financial markets since the early-1990s had wounded the political viability of the previous regime. The list includes the 1990 fraudulent failure of Asil Nadir’s Polly Peck, a stock-market star of the 1980s; accusations to the BoE of slowness in spotting the frauds which led to the July 1991 closing of the Bank of Credit and Commerce International; the collapse of the Maxwell empire;³³ and the still not fully resolved incident of mis-selling of pension plans by a range of advisers in the 1980s—an event which the government itself has referred to as “one of the worst scandals in financial services this century,” and whose cost in terms of consumer redress is currently estimated at about £11 billion. Beyond issues of efficiency intrinsic to a more integrated regulatory framework, it is clear that the driving force behind the move to a single regulator of U.K. financial markets, was the new U.K. Government’s desire to establish a system that would be publicly accountable and transparent in its supervisory practices.³⁴

69. In addition to its lack of transparency and inadequate accountability, the existing fragmented regulatory environment was also perceived as imposing unnecessary costs on the U.K.’s financial sector. Market participants viewed authorization and enforcement as ambiguous; supervisory responsibilities of the various supervisory bodies as overlapping and—in areas of overlap—as often working at cross purposes; information exchange between the various bodies as seriously deficient, when not outright non-existent, and causing significant increase in the data-reporting burden of authorized firms.³⁵ These problems are exemplified by the existing authorization process: under the current arrangement, firms must seek authorization under more than one statute, in some cases from as many as five or six separate regulators, each operating under a different set of powers.³⁶ Consumers of financial services have also found it difficult to determine the appropriate forum in which to file a complaint, resolve a dispute, and obtain compensation, facing no less than eight dispute-resolution schemes and five compensation schemes covering the financial services area.

70. Against this background, foremost in the government regulatory agenda was the desire to implement a structure whose political viability would be rooted in its transparency, clear attribution of responsibilities, accountability of decision-making, and—as much as appropriate—simplicity and homogeneity of regulation. In the event, maximum clarity of supervisory responsibility was sought by attributing all such responsibilities to a single body. Upon approval of the supporting legislation, this choice is to be counterbalanced by a number of elements, including: 1. formal mechanisms to secure the Authority’s public accountability; 2. information-sharing arrangements to strengthen the BoE’s role in support of the country’s financial system, including its monetary function and its responsibility for maintenance and improvement of the payments system; and 3. flexibility in prudential regulation, to assure that unification of supervisory responsibilities would not translate into a “one size fits all” approach to financial supervision. These items are discussed in the next sections.

D. Consumer Protection

71. In light of the perceived failure of the previous self-regulating system to protect consumers from abuses of financial services providers, the draft legislation assigns at least two of the FSA’s main institutional goals squarely to the area of consumer protection and education. One of these is to “secure the appropriate degree of protection for consumers,” while the other is to “promote public understanding of the financial system” (FSA, 1998e, p.6). Yet, while consumer protection is a major mandate of the FSA, the government has stated clearly that the FSA should not provide to consumers full insurance against authorized firms’ failure to deliver as contracted. Rather, the FSA’s goal is to promote “awareness of the benefits and risks associated with different kinds of investment or other financial dealing” while safeguarding “the general principle that consumers should take responsibility for their decisions” (Financial Services and Markets Bill, Clauses 4(2)(a) and 5(2)(c)).

72. In practice, the FSA plans to protect consumers of financial services by intervening at several stages: 1) by vetting firms at entry, to ensure that only those found to be “fit and proper” are permitted to conduct financial business; 2) by setting and enforcing prudential standards; 3) by using its powers of investigation, enforcement, and restitution against firms that fail to meet expected standards; 4) by setting a ‘one-stop’ arrangement for resolving disputes between consumers and authorized firms—the single “Financial Services Ombudsman Scheme”; 5) by overseeing the compensation of investors when an authorized firm is unable to meet its liabilities.

73. Unsurprisingly, the approach taken by the FSA to balance consumer protection with the preservation of strong elements of caveat emptor—consumers must take significant responsibility for their own financial decisions—has spurred a lively debate in the U.K.. Consumer interest groups have advocated the need for tighter regulation aimed at narrowing the scope for caveat emptor motives; financial services firms, at the other end, have advocated limiting the FSA’s power of prosecution and pointed to the cost of consumer protection for the competitiveness of the U.K.’s financial services industry.

74. The FSA’s powers are indeed wide—even if, in many cases, the FSA will consider it sufficient to make a public statement of misconduct (see Clause 135 of the draft Bill). The FSA will be able to intervene in the business of authorized firms to correct non-compliance, to try to contain financial loss (or risk thereof) for consumers and to investigate the circumstances leading to these; it will be able to seek restitution and to discipline instances of misconduct by bringing criminal proceedings for certain offences (essentially, insider dealing and misleading statements and practices), imposing civil fines for market abuse, and withdrawing authorization to conduct business.

75. Are these powers too extensive? International practice, as well as the overriding need to secure political viability of the reformed regime, suggest that this may not be the case. On the first count, for instance, U.S. financial supervisors enjoy comparable powers, being able to investigate and seek penalties for both firms and individuals, impose fines, and withdraw authorization to conduct business. In fact, the BoE’s lack of power to seek pecuniary penalties against banks had placed the U.K. among a minority of industrial countries subject to similar limitations.³⁷ The need to secure political support of the reformed regime, in light of the widely recognized shortcomings of the previous regime, also required a quantum leap in the attribution of powers to the post-reform regulators. More fundamentally, attribution of strong powers to impose penalties ex post, may be an efficient and cost-effective way for regulators to prevent frauds and market abuse, given the difficulty of implementing effective ex ante systems and controls.³⁸ The proposed legislation may have to be refined, to assure that it fits the standard of the European Convention on Human Rights and to further allay public concern with the Authority’s use of power.³⁹ However, it will be impossible for the FSA to specify in advance the exact contingencies under which it will exercise its investigative and punitive powers. Operationally, the most reasonable and feasible goal is to ensure acceptable windows of appeal against FSA decisions, proper procedures for independent re-trial, and overall accountability of the FSA towards the political body. The proposed framework, which establishes several mechanisms to mitigate concern with possible excessive use of force by the FSA, places these goals well within reach.

76. First, the FSA’s Board will continue to be appointed by the Chancellor of the Exchequer. Board members’ term of appointment—usually lasting three years—is also rather short by the common standards of public institutions, and can be terminated by the Chancellor, who thus retains effective control of the Authority’s governing body. The FSA’s Board will have to report annually to the Chancellor on the fulfilment of its statutory objectives, with the Board’s ten non-executive members charged with special reporting duties on the FSA’s internal mechanisms and use of resources. The FSA will also be required to consult publicly on its proposed rule changes; to perform cost-benefit analyses of proposed regulatory requirements and fee changes; and to subject rule changes to competition vetting by the Director General of Fair Trading. Firms or individuals being investigated by the FSA will be able to refer their cases, make oral representations, and see FSA evidence in front of an Enforcement Committee, established by the FSA Board, with members chosen from practitioners and public interest groups and chaired by an external full-time professional. The FSA’s enforcement and punitive decisions will also be subject to tight scrutiny. Firms will be able to appeal FSA decisions to the new, single Appeal Tribunal, established in complete independence of the FSA, as part of the Court Service administered by the Lord Chancellor’s Department. The tribunal will be formed by individuals drawn from a panel of legal and financial experts, appointed by the Lord Chancellor, and will have the power to substitute its own decisions for that of the FSA and to award costs against either the FSA or the appellants.⁴⁰

77. Overall, these requirements point to a dramatic improvement in the transparency and accountability of the financial supervisory process in the U.K., especially in the area of security trading, where formal public scrutiny of self-regulating agencies was hitherto minimal. Market participants, who generally welcomed the progress implicit in the move to a single regulator, had initially reacted vehemently to the draft Bill’s outline of the FSA’s enforcement powers, but have viewed the safeguards outlined in the consultation paper (FSA, 1998e)—discussed above—much more positively.

E. Coordination of Lender-of-Last-Resort and Supervisory Responsibilities

78. One of the main innovations the regulatory reform has introduced into U.K. financial system is the separation of the functions of banking supervision (henceforth attributed to the FSA) and provision of emergency liquidity (or LOLR, for which the BoE will continue to be responsible). This separation, which followed the Government’s recent granting of operational autonomy over monetary policy to the Bank of England, has generated a debate involving traditional arguments in favor and against lifting banking supervision responsibilities from the hands of an independent central bank.

79. Traditionally, advocates of a narrow role for central banks argue that if the central bank (or whichever institution performs the role of the LOLR) must provide liquidity assistance to avert a financial crisis, then it should do so only by providing liquidity to the market at large, e.g., through open market operations, leaving to the market the task of allocating liquidity to worthy borrowers.⁴¹ This conduct would minimize moral hazard, both for potential beneficiaries of liquidity rescues (which would have fewer incentives to assume socially excessive risks) and for other banks (who would need to step up peer monitoring and the associated market discipline). Expanding the role of a central bank to include supervisory responsibilities may also significantly raise the cost of a supervisory failure, which would damage the central bank’s reputation and the credibility of its monetary policy.⁴² Furthermore, the mandates of banking supervision and of price stability are subject to a potential conflict of interest: a central bank responsible for supervision could lean towards lax monetary policy if this was perceived to avert bank failures. Reflecting these viewpoints, countries such as Germany, Japan, and—recently—Australia, have established rather separate functions of banking supervision and of LOLR.⁴³

80. By contrast, countries such as the U.S., Italy, and (to some extent) France have opted for a broad central bank role, combining both monetary policy/LOLR and banking supervision responsibilities.⁴⁴ One argument in support of this approach emphasizes that a central bank charged with supervisory responsibilities gains information on the banking system which improves its ability to conduct monetary policy, by allowing it to better assess the transmission of monetary policy to prices.⁴⁵ This perspective is particularly useful, it is argued, in times of financial distress, given the failure of private markets to allocate liquidity efficiently among banks. In the absence of central bank intervention, such market failure would lead to excessive liquidation of banks and to financial instability.^46,47

81. Supporters of the link between the LOLR and supervisory mandates also argue that this link provides scope for the very existence of the LOLR mandate. This is because a LOLR can provide liquidity assistance more efficiently than the market only if it holds an informational advantage on the financial condition of financial institutions over the market itself. For instance, a LOLR endowed with intimate knowledge of a bank’s assets, liabilities, and overall position in the payment system, would be able to determine that a bank unable to borrow from the private market (because believed to be insolvent) was, in fact, merely illiquid. The LOLR can also use its privileged information to determine the quality of the bank’s collateral and the appropriate penalty to be charged on the rescue loan—commensurate with the bank’s responsibility for its own financial ills. If, instead, the LOLR determines that the bank is a candidate for closure, it can use its information on the bank’s financial structure, lenders, and clients, to assess the systemic implications of the bank’s wind-up.

82. How does a LOLR gain this informational advantage? By accessing bank-specific information collected in the course of its supervisory activity. This information must often be used within a very short time—sometimes within a few hours or minutes, as in the Bank of New York incident of 1985, when a computer failure threatened a payment system crisis and required prompt liquidity assistance by the Federal Reserve. And, armed with this information, a central bank could “use techniques that are less blunt [than flooding the market with liquidity through open market operations] and more precisely calibrated to the problem at hand. Such tools improve [the bank’s] ability to manage crises and, more importantly, avoid them.” (Greenspan, 1997). If the LOLR has no informational advantage, then it can efficiently lend funds only to institutions that could also borrow funds efficiently in the free market.

83. In any case, even if one subscribes to the need of maintaining a close informational link between the LOLR and the supervisory authorities, it does not follow that the same institution should play both roles. Rather, the implication is that—in case of separation—the two institutions should cooperate closely with each other, and that the LOLR should have swift and unrestricted access to supervisory information. In the case at hand, the issue is whether—in the event of a financial crisis—the BoE would have smooth and unrestricted access to the supervisory information collected by the FSA, and whether it would have the expertise to analyze it quickly, given the reassignment of most of its supervisory staff to the FSA in recent months.

84. Provision for effective information exchange between the Treasury, the FSA, and the BoE are made in a Memorandum of Understanding (see Appendix A) signed by the three institutions in October 1997. Not only does the Memorandum require the FSA to provide to the Bank “free and open access” to supervisory records;⁴⁸ it also establishes a number of channels to secure continued dialogue between the two institutions. These include cross-sitting of top management of the two institutions in their counter-party’s governing body, monthly meetings of a “Standing Committee” of the institutions’ top managers,⁴⁹ and programs of reciprocal staff secondment. Additionally, informal exchange will be aided, in the near future, by the recent transfer of many BoE supervisory staff to the FSA. Responsibilities for crisis management are also well defined, assigning to the BoE formal and technical responsibility for decision and implementation, subject to consultation with the Treasury and the FSA, and subject to the Treasury’s veto power on the decision to proceed with a rescue. Beyond formal assignment of responsibilities, in practice one expects a rather collegial handling of crises among the three agencies, reflecting the key nature of the information held by the FSA, and the Treasury’s overall responsibilities for supporting legislation, provision of fiscal resources, as well as its ultimate accountability to Parliament.

85. There are questions, of course, regarding the ability of crucial informal channels to continue to operate effectively once the inherited familiarity between BoE and FSA staff evaporates. There is also a tension between the basic argument underlying the U.K. regulatory reform—that merging supervisory responsibilities of nine separate bodies would foster regulatory synergies and smooth information flows—, and the argument that splitting LOLR and banking supervision responsibilities would not have an effect to the contrary. However, one should consider that even before supervisory responsibilities were transferred to the FSA, managing information within the Bank had become a major task, given the extraordinary growth of its banking supervision staff over the years. Furthermore, even in the pre-reform regime, the Bank was not acting in isolation from other regulatory bodies when crucial LOLR decisions had to be made—as the cooperation between the Bank and the SFA in handling the Barings episode demonstrates.

86. In most circumstances, the BoE, the FSA, and the Treasury would certainly have at their disposal the time necessary to coordinate on proper crisis management and resolution—as well as the appropriate accountability in place to secure the three institutions’ contribution to the task. Insight on the circumstances in which need for LOLR intervention would practically arise may be gathered by observation of the BoE’s record in this respect. Historically, the Bank has been very reluctant to undertake LOLR operations, following its stated policy of intervening only in support of banks whose failure could have systemic effects. In recent years, rescue operations were mounted only in 1984, in the case of Johnson Matthey Bankers Ltd., and in 1991, when the Bank intervened in response to pressure on the interbank market, resulting from a number of domestic clearing and foreign banks’—as well as local authorities’—withdrawal of funds from smaller banks and building societies.⁵⁰ By contrast, the BoE did not intervene in support of BCCI in 1991 and of Barings in 1995, viewing these banks’ closure as void of systemic implications. Thus, a scenario where the separation of LOLR and banking supervision responsibilities might challenge the BoE’s expertise and indirect access to supervisory information would have to feature a fast-breaking crisis, requiring immediate liquidity assistance, and having uncertain systemic implications. Emphasis on systemic risk as pre-condition for LOLR support, the Bank’s continued responsibility for support of the nation’s financial system, and its independent access to information from the domestic and international financial markets and payments systems, however, suggest that the Bank would continue to hold expertise in most cases when called upon intervening without much time to consult with the FSA—as in a Bank-of-New-York style payments failure, for instance. But the BoE and the FSA must stand ready to implement the necessary changes in their information-sharing arrangements to assure their effective cooperation during crisis events whose non-‘technical’ nature require complex and rapid decisions.⁵¹ In recent months—including the eventful Fall 1998 period—existing arrangements have been reported as effective in securing information exchange and cooperation between the two institutions. Preventing the two institutions from drifting apart as they settle into their separate mandates and the inherited familiarity between the two institutions’ staff vanishes, will be key to the continued success of this experience.

F. “Constructive” Ambiguity?

87. A widely held view among advocates of an active LOLR mandate is that central banks (or whoever performs the function of LOLR) may deter banks’ tendency to assume excessive risk by keeping details of LOLR practices “constructively” ambiguous, i.e., by retaining discretion as to whether, when, and at what conditions, emergency liquidity support will be provided.⁵²

88. One basis for this view rests on the presumption that risk-averse banks will respond to greater uncertainty, both on the terms of a bail-out and on whether liquidity assistance will be provided or not, by reducing their engagement in risky activities (see, for instance, Corrigan, 1990). Another argument emphasizes that a LOLR should retain discretion on the exact terms of a rescue (including relevant penalties) so as to be able to tailor them to the specific contingencies of the bail-out: higher penalties (possibly, a wind-up) should be imposed for banks that are found to be responsible for their own financial ills—so as to penalize moral hazard in their choice of portfolios; vice versa for banks who fall victims to external circumstances.

89. Countering the benefit of reduced moral hazard, ambiguity undermines supervisors’ accountability, by making their responsibilities less clearly defined. It also induces a bias towards forbearance: a supervisor may allow a troubled bank to continue to operate with the hope of its eventual recovery, especially if it was a supervisory failure that prevented early detection of the problem. Finally, it may increase the scope for inefficient bail-out policies: lacking pre-commitment to a detailed rescue policy, a LOLR may be more lenient with banks ex post than threatening ex ante; recognizing this incentive, banks will respond by assuming an excessive amount of risk in their portfolios.

90. Accordingly, regulators must walk a fine line when designing LOLR mechanisms. Traditionally, the trade-off between rules and discretion in the design of LOLR procedures has been tackled by maintaining ambiguity on the exact terms of a liquidity rescue, but by clarifying decision-making responsibilities and the decision-making process. From this viewpoint, the U.K. model for crisis-management falls squarely in this category: while the division of responsibility between BoE, FSA, and Treasury in the event of a crisis is well specified, the exact terms of the emergency response are not. Paragraph 12 of the Memorandum, in particular, stipulates that “The form of the response would depend on the nature of the event and would be determined at the time”. Paragraph 13 even maintains ambiguity on whether liquidity assistance would actually be provided or not: “the Bank and the FSA […] would immediately inform the Treasury, in order to give the Chancellor of the Exchequer the option of refusing support action.” The Bank of England—similar to the U.S. Federal Reserve, and unlike the Bundesbank—also enjoys considerable discretion in deciding what type of collateral may be acceptable in exchange for emergency liquidity provision.

91. Thus, the extent of ambiguity in the U.K.’s approach to emergency liquidity operations is fairly standard and intentional. In this context, however, prompt sharing of information by the FSA with Treasury and the Bank; transparent (at least ex post) account of decisions to rescue or close a financial institution; and adequate sharing of costs of failures among managers, share-holders, and creditors, will be essential in securing the economic and political viability of the system. The appropriate legislative ingredients are being assembled. Only experience will tell whether the new regulatory regime will resolve the subtle tradeoff between discretion and transparency—in essence, whether the ambiguity introduced into the mix is “constructive” or just plain “ambiguous.”

G. Regulatory Reform and Financial Innovation

92. Like most financial regulatory systems of the leading industrial countries, the U.K.’s pre-reform framework largely reflected the product segmentation prevailing in financial markets until the 1980s, involving a marked separation between banking, securities, and insurance activities and the resulting assumption that banks would incur risks mainly in connection with their lending activities—the “credit” risk that a borrower would fail to meet its loan obligations. This structure justified separate regulatory agencies and prudential requirements for each activity, resulting in the absence of a single regulator in charge for examining the whole of a complex group’s activities. The perception that credit risk could usually be identified in advance—and was relatively stable at high frequency—also underlay the rather infrequent (usually quarterly) collection of information and limited disclosure.

93. The major expression of this regulatory approach was the Basle Capital Accord of 1988, as reflected in the EC’s Solvency Ratio Directive, implemented in the U.K. in December 1990. This system hinges on requirements that a financial institution should maintain minimal ratios between its capital and its risk-weighted assets, the latter computed based on a building-block methodology weighting various assets by their individual riskiness. Following the deregulatory initiatives of the 1980s, the blurring of the demarcation between traditional banking and other financial activities and the growing exposure of banks and other financial institutions to fluctuations in the prices of their securitized assets clearly showed the traditional system of regulation to be inadequate. Regulators increasingly recognized that ‘market risk’ had to be taken into account when assessing a financial institution’s exposure to shocks. Moreover, they also had to grapple with the growing ability of financial operators to un-bundle, repackage, and trade risks in increasingly creative ways, so much so that the regulators’ task of assessing the distribution of private financial risk across institutions, markets, and countries, was becoming increasingly arduous. This was especially so if regulators were working in a fragmented fashion, and were constrained to focus on a single aspect of an institution involved in a broad array of financial activities and in the trade of a variety of hybrid financial assets.

94. Recent EU directives in the area of financial regulation have enhanced the ability of EU regulators to cope with financial innovation. The Capital Adequacy Directive (CAD), implemented in the U.K. in January 1996, extends the prudential framework to consideration of market risk, and provided some scope for regulators to recognize internal models for risk assessment. CAD II, implemented in the U.K. at end-September 1998, builds on the 1997 Amendment to the Basle Accord and further expands the scope for financial institutions to use internal risk-assessment models, covering potentially all of an institution’s risks.⁵³

95. Through the ongoing regulatory reform and the associated move to a single financial markets regulator, U.K. regulators are also seeking to overcome the difficulty of assessing and managing risk in complex financial institutions. Within the new regulatory framework, groups of authorized firms or firms with more than one authorization will be subject to lead supervision within the FSA that will identify a single supervisor responsible for coordinating the FSA’s supervision of the group or firm, including the assessment of the overall risk exposure of the group. The FSA has identified about 55 institutions whose multi-functionality qualifies them for such treatment, and plans to begin by experimenting with unified supervision of a limited number of such groups.

96. Integrated supervision does not mean that U.K. regulators will seek to homogenize prudential requirements across different lines of business. In fact, flexibility in prudential requirements is entrenched in U.K. regulation: capital requirements differ not only across financial sectors, but among firms in the same sector, in recognition of the specificity of risks associated with each institution. However, the ongoing reform is aimed at providing a level playing field across financial sectors with respect to authorization procedures, standards for consumer protection, enforcement process, and appeal procedures. Emblematic will be the FSA’s approach to consumer protection, where the Authority’s main goal is to establish criteria for “fitness for purpose” applicable across financial sectors and a common prosecution procedure for all authorized firms.

97. Through the establishment of an agency with a unified view on complex groups’ activities, U.K. regulators also hope to make inroads towards monitoring and controlling the vulnerability of U.K. financial markets to international risk factors: multi-functional conglomerates, after all, tend to be the same groups that take positions on an international scale, and provide the crucial link—particularly in times of crises—among payment systems of different countries. However, in their effort to control the role of complex groups in transmitting risk internationally, U.K. regulators face an internationally common plight.

98. Contrasting with the increasingly international integration in the provision of financial services, the supervision of financial markets has remained a national preserve, despite considerable progress made in harmonizing national regulations. Home-based supervision of activities with significant cross-border spill-over effects implies—in typical public finance fashion—shortcomings in the efficient provision of supervisory effort. First, no single national regulator has an overall picture of an international conglomerate’s activity, thus exacerbating information asymmetries and the resulting incentives for international conglomerates to assume excessive risk. Second, no single supervisor reaps the full benefit of its effort to avoid a global financial crisis, thus typically leading supervisors to expend less-than-optimal crisis-prevention effort. Third, should a crisis indeed occur, no single national regulator or LOLR could adequately assess its overall implications, nor feel sufficiently responsible for bearing the cost of its resolution.

99. One answer that the regulatory community has given to this problem is to harmonize national regulations internationally, while leaving the implementation of supervisory effort decentralized. This strategy provides a partial answer to the need for international coordination, mitigating the scope for financial firms to arbitrage across regulatory regimes.⁵⁴ However, capital standards remain rather heterogeneous internationally, despite the auspices of the Basle Committee and the implementation of a number of relevant EU directives, for instance reflecting cross-country differences in the activities admitted as required capital Supervisory practices also continue to vary significantly across countries (see Barth, Nolle, and Rice, 1997, and Prati and Schinasi, 1998, for a discussion). At least, memoranda of understanding, such as that agreed upon by the FSA and the BoE with the U.S. Security and Exchange Commission and Commodity Futures Trading Commission in 1997, attempt to establish procedures for supervisory cooperation and sharing of information. Nevertheless, some observers have seen these efforts as limited in their goal of clearly assigning responsibilities for crisis management and resolution, and the U.K. government and supervisors have advocated the establishment of more structured fora to tackle these issues—a sort of “Global Standing Committee”—, involving national regulators, the IMF, and other multilateral agencies.

100. While these efforts are ongoing, the U.K.’s regulatory reform will at least magnify its regulators’ perspective on global issues, through their enhanced viewpoint on complex groups. Indeed, some BoE officials have noted that their ability to handle and resolve a financial crisis may have been strengthened by moving from a narrow (but direct) perspective on the banking sector, to a global (though partly indirect—through FSA intermediation) perspective on the U.K. financial sector as a whole.

101. The ongoing reform of financial regulation may also contribute to increase the appeal of the City’s market with respect to its foreign counterparts. Pending further progress, for instance, EMU financial institutions will be operating under a fairly complex framework, whose management will be split among a multitude of institutions (ECB, national central banks, regulators and treasuries, etc.), without a clear LOLR mandate nor well-defined arrangement for crisis management and resolution (see Prati and Schinasi, 1998, for a discussion). Ceteris paribus, London’s traditional appeal in terms of a well-developed legal framework, light regulatory burden, and supporting legal and accounting services will be enhanced by a more coherent and transparent supervisory framework. This is no small matter for a major world financial center which—unlike either New York or Tokyo—is not backed by a large domestic economy.

H. Concluding Remarks

102. Clearly, an issue that will be long debated will be whether the move to a single regulator is the most effective way to address the shortcomings of the pre-existing regime, or whether a shared arrangement such as that prevailing in the U.S. and other countries would have better safeguarded against excessive homogenization of supervisory practices across heterogeneous financial activities and against the creation of an all-too-powerful regulatory body. On the whole, however, the ongoing U.K. reform has struck a good balance, by providing adequate flexibility for the supervisory arrangement to deal with the country’s diverse financial environment, and by implementing a series of checks to make the single regulatory body accountable to Parliament and to the public at large. The government has clearly identified areas where establishing common procedures across financial activities is beneficial: a single authorization process, a single compensation scheme, a single ombudsman scheme, a single appeals tribunal, and new common powers to tackle market abuse. At the same time, it has also identified areas where differences among financial sectors have to be maintained—mainly with respect to prudential treatment.

103. There are areas where U.K. regulators are likely to encounter challenges. Some of these challenges reflect, to a large extent, the innovative nature of the newly established framework, such as the separation of supervisory and LOLR responsibilities. Other challenges pre-exist the reform, including strengthening supervisory practices along recently planned lines and the difficulty of supervising a large, internationally integrated financial market. In light of these challenges, and given the novel and comprehensive nature of the reform, legislative flexibility—the government’s willingness to adapt the regulatory framework in response to emerging needs—will be the key to keeping up with an industry in continuous and rapid evolution.

Table 1.

Monetary and Supervisory Agencies

Source: elaboration on Goodhart and Schoenmaker (1995). Note: The sample covers the OECD countries, Hong Kong, China, and Venezuela. CB = Central Bank, MEA = Ministry of Economic Affairs, MF = Ministry of Finance.

Table 1.

Monetary and Supervisory Agencies

Country	Monetary Agency	Supervisory Agency
Australia	Reserve Bank of Australia (CB)	Australian Prudential Regulatory Authority
Austria	National Bank of Austria (CB)	(Federal) Ministry of Finance (MF)
Belgium	National Bank of Belgium (CB)	Bank and Finance Commission
Canada	Bank of Canada (CB)	Office of the Superintendent of Financial Institutions (MF)
Denmark	Danmarks Nationalbank (CB)	Financial Supervisory Agency (MEA)
Finland	Bank of Finland (CB)	Financial Supervision Authority (CB)
		Bank of Finland (CCB)
France	Banque de France (CB)	Banque de France (CB) Commission Bancaire
Germany	Deutsche Bundesbank (CB)	Federal Banking Supervisory Office Deutsche Bundesbank (CB)
Greece	Bank of Greece (CB)	Bank of Greece (CB)
Hong Kong, China	Hong Kong Monetary Authority (CB)	Hong Kong Monetary Authority (CB)
Ireland	Central Bank of Ireland (CB)	Central Bank of Ireland (CB)
Italy	Banca d’ltalia (CB)	Banca d’ltalia (CB)
Japan	Bank of Japan (CB)	Financial Supervisory Agency
Luxembourg	Luxembourg Monetary Institute (CB)	Luxembourg Monetary Institute (CB)
Netherlands	De Nederlandsche Bank (CB)	De Nederlandsche Bank (CB)
New Zealand	Reserve Bank of New Zealand (CB)	Reserve Bank of New Zealand (CB)
Norway	Norges Bank (CB)	Banking, Insurance and Securities Commission (MF)
Portugal	Banco de Portugal (CB)	Banco de Portugal (CB)
Spain	Banco de Espana (CB)	Banco de Espana (CB)
Sweden	Sveriges Riksbank (CB)	Swedish Financial Supervisory Authority
Switzerland	Swiss National Bank (CB)	Federal Banking Commission
United Kingdom	Bank of England (CB)	Financial Services Authority
United States	Federal Reserve Board (CB)	Office of the Comptroller of the Currency (MF)
		Federal Reserve Board (CB)
		State governments
		Federal Deposit Insurance Corporation
Venezuela	Banco Central de Venezuela (CB)	Superintendency of Banks

Source: elaboration on Goodhart and Schoenmaker (1995). Note: The sample covers the OECD countries, Hong Kong, China, and Venezuela. CB = Central Bank, MEA = Ministry of Economic Affairs, MF = Ministry of Finance.

View Table

Table 1.

Monetary and Supervisory Agencies

Country	Monetary Agency	Supervisory Agency
Australia	Reserve Bank of Australia (CB)	Australian Prudential Regulatory Authority
Austria	National Bank of Austria (CB)	(Federal) Ministry of Finance (MF)
Belgium	National Bank of Belgium (CB)	Bank and Finance Commission
Canada	Bank of Canada (CB)	Office of the Superintendent of Financial Institutions (MF)
Denmark	Danmarks Nationalbank (CB)	Financial Supervisory Agency (MEA)
Finland	Bank of Finland (CB)	Financial Supervision Authority (CB)
		Bank of Finland (CCB)
France	Banque de France (CB)	Banque de France (CB) Commission Bancaire
Germany	Deutsche Bundesbank (CB)	Federal Banking Supervisory Office Deutsche Bundesbank (CB)
Greece	Bank of Greece (CB)	Bank of Greece (CB)
Hong Kong, China	Hong Kong Monetary Authority (CB)	Hong Kong Monetary Authority (CB)
Ireland	Central Bank of Ireland (CB)	Central Bank of Ireland (CB)
Italy	Banca d’ltalia (CB)	Banca d’ltalia (CB)
Japan	Bank of Japan (CB)	Financial Supervisory Agency
Luxembourg	Luxembourg Monetary Institute (CB)	Luxembourg Monetary Institute (CB)
Netherlands	De Nederlandsche Bank (CB)	De Nederlandsche Bank (CB)
New Zealand	Reserve Bank of New Zealand (CB)	Reserve Bank of New Zealand (CB)
Norway	Norges Bank (CB)	Banking, Insurance and Securities Commission (MF)
Portugal	Banco de Portugal (CB)	Banco de Portugal (CB)
Spain	Banco de Espana (CB)	Banco de Espana (CB)
Sweden	Sveriges Riksbank (CB)	Swedish Financial Supervisory Authority
Switzerland	Swiss National Bank (CB)	Federal Banking Commission
United Kingdom	Bank of England (CB)	Financial Services Authority
United States	Federal Reserve Board (CB)	Office of the Comptroller of the Currency (MF)
		Federal Reserve Board (CB)
		State governments
		Federal Deposit Insurance Corporation
Venezuela	Banco Central de Venezuela (CB)	Superintendency of Banks

Source: elaboration on Goodhart and Schoenmaker (1995). Note: The sample covers the OECD countries, Hong Kong, China, and Venezuela. CB = Central Bank, MEA = Ministry of Economic Affairs, MF = Ministry of Finance.