On February 17, the Treasury published its latest consultation document, called A new approach to financial regulation: building a stronger system. It sets out a number of laudable regulatory principles which will be at the heart of the new regulatory system. Few would quarrel with them.
The problem is that when one looks at the current and recent performance of the FSA, it is reasonable to ask whether the new Financial Conduct Authority will be able to live up to those principles, especially as the FCA will inevitably be staffed and run by more or less the same people who are now in the FSA.
It is instructive to look at the first two of those principles. The first is that the FCA must take responsibility for using “its resources in the most efficient and economic way”.
The second principle is that “a burden or restriction imposed on a person or activity should be proportionate to the benefits which are expected to result… Proportionality also means that the regulator must tailor its actions to the specific characteristics of the sector being regulated…”
Neither of these principles looks new or revolutionary. It is fair, therefore, to consider how well the FSA has done in practice to live up to them.
The FSA is a huge organisation and if it does not have the skills in house it is able to call on all the skills and brains in the UK. Yet it missed the problems at Northern Rock which caused that firm to collapse. Chief executive Hector Sants had to concede in public: “As we have already made clear, the failure of Northern Rock should first and foremost be attributed to the failure of its board and executive to create a durable funding model…Nevertheless, the FSA acknowledges that its supervision of Northern Rock…was not of sufficient intensity or appropriate rigour to challenge the company’s board and executive on their risk management practices and their understanding of the risks posed by their business model.”
In other words, the FSA ought to sharpen up its act. This is not a good example of the organisation using its resources efficiently and economically. Neither is it a good example of the proportionate allocation of its resources. What was the FSA busy doing while Northern Rock was going bust?
Look at HBOS. Up to the end of 2004, Paul Moore was its head of group risk. He was dismissed. Early in 2009, he gave written evidence to the Treasury select committee and became known as the HBOS whistle-blower.
In his written evidence, he said: “When I was head of group regulatory risk at HBOS, I certainly knew that the bank was going too fast (and told them), had a cultural indisposition to challenge (and told them) and was a serious risk to financial stability (what the FSA calls maintaining market confidence) and consumer protection (and told them). I told the board they ought to slow down but was prevented from having this properly minuted by the CFO. I told them that their sales culture was significantly out of balance with their systems and controls.”
As a result of his disclosures, the FSA felt compelled to issue a press release on February 11, 2009. It speaks volumes about the FSA’s own performance as well as that of HBOS. The FSA said that it had carried out a full risk assessment of HBOS in late 2002, in which “it identified a need to strengthen the control infra- structure within the group”.
Another risk assessment followed a skilled person’s report in 2004 and the FSA concluded “that the risk profile of the group had improved…but that the group risk functions still needed to enhance their ability to influence the business…”
After Paul Moore’s dismissal at the end of 2004, the FSA continued to pursue its concerns, and wrote to HBOS on June 29, 2006 – that is about 18 months after Moore’s dismissal – with yet a further risk assessment.
The FSA’s letter said there were still control issues and it would closely track progress in this area. In its letter, the FSA added that “the growth strategy of the group posed risks to the whole group and that these risks must be managed and mitigated”.
Not long afterwards, HBOS failed – a full six years after the FSA’s 2002 risk assessment.
That press release begs the question of what steps the FSA itself took to ensure the risks to the whole group were indeed managed and mitigated, and why, if the FSA did act, did HBOS still fail?
Again, the picture is of a regulator being inefficient and ineffective. It had spotted the problem but had not done anything effective about it. Both the examples of Northern Rock and HBOS suggest that the FSA was not allocating its resources appropriately or proportionately. The lesson in both cases was that it needed to sharpen up its act.
The HBOS case is particularly shocking. The FSA itself said in the press release quoted above that it was aware of the fundamental problem at HBOS – that of the group’s growth strategy posing risks for the whole group – but it plainly failed to bring about a sufficient change to prevent failure.
It will not do for the FSA to say in reply that it cannot be expected to eliminate the risk of firms failing, because it was on to the HBOS problem. It had all the powers it could possibly have needed to bring about a radical change. In the interests of the country, why did it not use those powers effectively?
We still await a report about HBOS and a full report about the Royal Bank of Scotland. It will not be a surprise if the general conclusions relating to the FSA’s own performance are that it failed to act properly or in time.
The fourth principle in the Treasury’s consultation document is that senior management of authorised firms are responsible for securing compliance with the regulatory framework. The FCA cannot be expected to replace the proper decision-takers.
The Treasury’s document goes on to say: “The FCA, however, will be expected to hold senior management accountable for ensuring that their firms meet regulatory standards and to be prepared to take action if they fail to do so”. There has been no significant action by the FSA in relation to the senior management of Northern Rock, HBOS, or for that matter, RBS.
When the FSA announced it had completed its investigation into RBS in December 2010, the FSA said its “review confirmed that RBS made a series of bad decisions … However, these bad decisions were not the result of a lack of integrity by any individual and we did not identify any instances of fraud or dishonest activity by RBS senior individuals or a failure of governance by the board The issues we investigated do not warrant us taking any enforcement action, either against the firm or against individuals”.
So why did RBS fail? When the FSA made its announcement, there was widespread outrage and disbelief that despite the finding of “bad decisions”, no one was found to be at fault.
Will things be different when the FSA becomes the FCA? To believe so would be a triumph of hope over experience.
Peter Hamilton is a barrister specialising in financial services at 4 Pump Court