UK financial-sector regulation: Just don’t call it Big Bang 2.0

If a regulation is introduced and then its punishments are hardly ever used, does that mean it has or hasn’t worked? You could look at it both ways.

One view – a regulator’s, perhaps – would be that the new rules scared off the bad behaviour so effectively that no one dared misbehave. This we might call the ‘Draghi bazooka’ approach to regulation – a preventative promise to do ‘whatever it takes’ and never actually have to pull the trigger.

On the other hand, one could argue that rarely having held anyone to account under new rules proves only that someone is not very good at enforcing the rules – or that they are unfathomably difficult to enforce in all but the clearest cases.

And so here is UK Chancellor of the Exchequer Jeremy Hunt writing last week about a proposed review of the UK’s Senior Managers and Certification Regime (SM&CR), which was originally put in place in 2016 to focus the minds of senior financial services professionals on the potential risks of their activities rather more than they had been in the run-up to the financial crisis nearly 10 years earlier: “The government will launch a Call for Evidence to look at the legislative framework of the regime, and the FCA [Financial Conduct Authority] and PRA [Prudential Regulation Authority] will review the regulatory framework. The government's Call for Evidence will be an information gathering exercise to garner views on the regime's effectiveness, scope and proportionality, and to seek views on potential improvements and reforms.”

This doesn’t, admittedly, tell us very much, but the assumption is that the intention is to weaken the regime at some point. The PRA and the FCA have both expressed their confidence in it over the years, arguing that regulated firms report that it has improved individuals’ behaviour and that the low number of enforcement actions under the SM&CR is merely confirmation of how well it is working.

Well, maybe. But is it really proportionate to threaten senior managers with potential custodial sentences for getting something wrong? After all, plenty of other laws exist to deal with criminal dishonesty and wrongdoing. The SM&CR is surely not there to deal with that, but something else.

But what? Interfering with a whistleblowing investigation, perhaps?

When Barclays then chief executive Jes Staley fell foul of regulators for such an incident in 2018, many were surprised that he suffered little more than a £642,430 slap on the wrist after the regulators said he failed to act with due skill, care and diligence but said he had not breached the requirement to act with integrity.

The bank itself was fined $15 million for the same affair by the New York state department for financial services a few months later.

Staley eventually left the bank in 2021 after another regulatory investigation found that he had not accurately described to the bank his relationship with convicted sex offender Jeffrey Epstein – a finding he said he would contest, which was the formal reason for him leaving his post.

But there is a bigger point here too, which is that the SM&CR was intended to hold senior managers accountable for what happened at their firm, even if it was the fault of others, rather than acting as a new way to monitor their own behaviour. But the examples so far have tended to be focused on an individual’s own behaviour.

Is that because it has in practice proved difficult to show that someone more senior could have and should have been aware of something or prevented some action? Or is it simply that the regime is doing its job?

What critics of the SM&CR also argue is that far from making the industry safer and decision-making better, the regime has let boards and other senior management off the hook.

In the past, they argue, if a risk call or a business decision was utterly egregious, boards would get rid of CEOs and executive committees would get rid of senior managers. Now, the theory goes, this kind of decision is increasingly outsourced to regulators. If they don’t flex their muscles then no one else will, and if they only do it occasionally or inconsistently, then all that has been introduced is a new level of arbitrariness.

And anecdotally, the certification process is also frustratingly clunky: even senior banking staff working in compliance itself can take more than a year to receive approval.

Gripes of that sort may hold more water than another regular criticism of the regime, that it so terrifies potential top talent that it stifles the market for senior executives, and particularly when it comes to US imports.

Some who have been close to the top of banking in the UK in the past dismiss that kind of talk, argue that all regulators can be somewhat capricious and say that bankers are well used to dealing with that.

Here’s what one former very senior executive says: “When you put yourself into one of these big jobs, you know it’s a political thing and that you are in an industry that is by its very definition political. You fully accept that arbitrary things can happen to you. If you are sitting in the US, there are a million reasons why you might or might not take up a senior UK role and the SM&CR will not make your call.”

The proposed changes to the SM&CR are in the news because they are part of something bigger, much bigger – although also not big enough to be called a 'Big Bang'. On December 9, Hunt went all the way to Scotland to announce the so-called “Edinburgh Reforms”.

But for all the energy that the government is trying to inject into the package of about 30 measures that Hunt announced – many of which will be a long time in the making as they will require consultations and secondary legislation and other such tiresome things – these are proposals that have been in the works for some time.

Back in January 2021, then-chancellor Rishi Sunak was full of excitement about the prospect of reforms to the way that the UK’s financial services sector worked, some of which – it is claimed – have been made possible by the country’s exit from the European Union.

But Sunak struggles to do hyperbole, telling CityAM back then that the package was “a whole range of things we can do slightly differently”.

That’s hardly a man leading a revolution.

And that is surely a good thing. Back then, Sunak sounded pretty relaxed about what exactly this transformative package should be called, “whether you want to call it Big Bang 2.0 or whatever”.

Erase that memory right now. In the wake of the short-lived dream team of prime minister Liz Truss and this year’s chancellor 3.0 Kwasi Kwarteng, we must call it anything other than Big Bang two-point-oh. That kind of talk is so September 2022.

The Edinburgh Reforms please – 'Edinburgh' because it’s not about London (although it mostly is), and 'Reforms' because they make things better and sound less like blowing things up. Less levelling, more levelling-up.

For TS Eliot, the natural contrast to a bang was a whimper, and perhaps that is what Hunt secretly fears too. Sunak might have had it right the first time around. “A whole range of things we can do slightly differently” is a pretty fair summary of what he’s putting forward.

That is partly out of necessity – yes, many of the measures have been knocking around in one guise or another for years, but the new government has not had enough time to construct the kind of coherent full-blown reform package that it is trying to sell this as.

And for that reason, this is more a case of dressing up an assortment of smaller moves into one long list to try to get more bang (sorry) out of the announcement.

It is a tricky balance to strike. On the one hand, Sunak, Hunt & co want to make what they are doing sound consequential. On the other, they don’t want to make it sound too consequential for fear of accusations of letting the City run riot in a bonfire of regulations.

So, please pay attention to all this exciting stuff we’re doing, but also don’t forget that things like scrapping the cap on bankers’ bonuses are dull and not worth complaining about.

None of which is to say that the Edinburgh Reforms – or much of them – don’t make any sense at all.

Take proposed tweaks to the ring fence, which is the point at which the world of the global financial crisis meets the world of high-street banking. Brought in to protect UK retail banking from overseas adventures or the wild west of the financial markets, it was a response to the crisis that sought to make risky businesses able to fail without bringing down retail banks that would then need to be bailed out.

But a very tight ring fence carries unintended consequences with it too. If you are a business operating inside the ring fence, your capacity to do things is constrained and so the danger is that you end up loading up on a few different flavours of the same kind of risk. Your mortgage exposure might be to the same folk as your unsecured credit exposure, for instance. You are probably also lending to the property developers. And then when you consider that all your competitors are in much the same boat, the risk is of exposures that can quickly become concentrated.

It is easy to see a reasonable argument for a ring fence of some sort – if you are a global bank that does business in the UK, there needs to be a mechanism to ensure that your UK retail business cannot be infected by what you are doing outside the UK. Equally, it seems sensible to make sure that retail banking can’t be sucked underwater by a bank’s wholesale business.

Both of these seem justified by the explicit guarantee of retail deposits offered by the government – and the implicit support that goes much further than that.

But it has also long been recognised that there might need to be a discussion around precisely how the ring fence is defined. The measure only came into force in 2019, even though it had been enacted through legislation in 2013. And built into the legislation was a requirement to review the ring-fence regime after two years.

That independent review (Keith Skeoch's Independent Panel on Ring-fencing and Proprietary Trading) reported its findings in March 2022, recommending among other things that the ring fence be changed to focus more on the biggest and most complex banks, and exempting those that can be easily wound up as the resolution regime becomes embedded in the sector.

The Edinburgh Reforms propose taking banks that do not have large investment banking businesses out of the regime altogether, something that will no doubt delight the challenger banks that have long complained of being subject to the same onerous responsibilities as their much bigger cousins.

A proposed move to also lift the applicable deposit base from £25 billion to £35 billion was not in the Skeoch review but would be useful to foreign banks in the UK.

More freedom to do things like hedge inflation and mortality risk is also on the cards. Inflation hedging is needed for project finance, among other things, and the review noted that the fact that ring-fenced banks are not allowed to enter into these swaps means that they have to create a more complex transaction that involves their non-ring-fenced entity.

Likewise, while their inability to hedge mortality risk might not entirely explain ring-fenced banks’ reluctance to offer lifetime mortgages, it is pretty hard to offer the product without it.

In the Edinburgh Reforms, two measures in particular have attracted more controversy than most. One was the government’s proposed ability to call in regulatory decisions, something that Bank of England governor Andrew Bailey has made clear he dislikes and which the government has now decided to drop – for the moment. It is still expected to attempt to introduce it later.

The other is the broader principle of using the country’s regulatory regime to bolster the UK’s competitiveness versus international competitor finance hubs. The UK’s regulators have long had secondary competition objectives, but these have concerned themselves with ensuring that regulation does not have the effect of stifling competition within the UK market itself.

In letters to the FCA and the PRA, Hunt has now issued new recommendations to both institutions setting out new secondary objectives around the competitiveness of the UK as a global financial centre.

In Hunt’s view, that means helping the government get through its mammoth Future Regulatory Framework Review – the process by which the UK is deciding what to keep and what to ditch of the European Union regulatory regime. It also means ensuring that the country is attractive to international financial services firms. And it means supporting innovation and new technology, including crypto technologies.

That is a lot. But the newish head of the FCA, Nikhil Rathi, already sounds on message. In a Mansion House speech in late October, he said that the organization would “embrace” a secondary objective of promoting growth and competitiveness.

Is he right to do so? Is the government straying too far? There are plenty of voices arguing that for regulations to be deployed in support of an objective for international competitiveness will inevitably lead to some regulatory race to the bottom. How could it not?

Such concerns are understandable, but perhaps overdone. To think that competitive advantage in regulatory areas must by definition mean being riskier is to misunderstand what financial market participants find appealing about regulation and what they do not.

Firstly, the strictness of regulation is not what holds financial centres back, but rather its cumbersome or inefficient implementation and its unpredictability. After all, the UK’s legal traditions have given its financial markets good standing around the world and have served as a template for many other legal jurisdictions. That standing has not come about from some perception of UK law as lax. Quite the opposite.

The Truss/Kwarteng episode provides some evidence for this. The moment that the perception of the UK as a rational and predictable actor in fundamental areas of economic policy was lost, was the moment when the biggest damage was done.

But even with regulators acting to help promote the UK as a financial centre, can the Edinburgh Reforms package really make the difference? Talking to London-based bankers, one gets the sense of some hope around long-running aspects such as the Wholesale Markets Review, which aims to tackle frustrations stemming from the European Union’s Markets in Financial Instrument Directive (Mifid II), but still more broadly a collective shrug of the shoulders.

Financial sector reform packages are ultimately less about reform than they are about serving the ends of the administration in power at the time. In the wake of the global financial crisis, it suited politicians to construct a package that went some way to reflect public anger at an industry that taxpayers had been forced to bail out. In the wake of Brexit – and with a government in sore need of some defining policy to help it move away from the chaos of recent months, while elections loom – another package is being deployed in the cause of some Great British renaissance.

The reality is obviously going to fall short of that – one does not need to be a rabid Remainer to observe that for the financial services sector nothing will replace the pre-Brexit relationship with the European Union. But seeing Hunt and Sunak cheerleading for the UK in financial services does mean something. It is a sign of intent, and an acknowledgement that this industry is something that the country should care about, in spite of 2008.

Will anything change? Yes, but doubtless not as much as hoped and not as smoothly. The announcement in Edinburgh may be the last part of this process that looks coordinated.