The focus on bankers’ conduct continues to intensify even as tentative signs of economic recovery appear and the impact of the financial crisis begins to recede. The debate remains highly politicised. The public remain angry over bankers’ pay and behaviour, having borne the brunt of the economic detriment from the financial crisis. Politicians and regulators are still searching for effective measures to modify culture and behaviours in the banking industry, and to drive individual responsibility. The banking industry voices frustration about the heavy cost of regulation, and wonders when they will be able to put this all behind them.
The Parliamentary Commission on Banking Standards (the Commission) released its 571 page report, Changing banking for good. It raises many important issues and proposes a number of solutions which Government, the regulators and industry will want to consider in detail over the coming weeks. Further developments may emerge over the coming days and weeks. The report gives us an indication of the direction of travel, but the analysis and commentary below should be viewed as provisional.
The Commission's report is another important milestone in reforming the UK's banking and regulatory systems. In deciding which recommendations to implement, the Government needs to build upon prior reforms, particularly those emanating from Europe, while ensuring that London remains competitive as an international financial centre.
For those working in the banking industry, the Committee’s proposals on corporate governance, and senior management responsibility and remuneration will certainly focus their minds even more strongly on the way they discharge their responsibilities, and on the 'risks and rewards' of holding such positions.
The Commission recommends wholesale changes to reinforce individual responsibly of both senior management and wider staff in banks.
i. Senior Persons and Licensing Regimes
The Commission savagely criticises the ‘mess’ of the current Approved Persons Regime (APR), describing it as ‘failing to perform any of its varied roles to the necessary standard’. The Commission proposes replacing the APR with a new two tier system:
(a) A new ‘Senior Persons Regime’ (SPR) - replacing the Significant Influence Function (SIF) elements of the APR. Individuals will have more specific regulatory responsibilities, enabling the regulators to take more targeted enforcement measures. The SPR would apply to fewer individuals than the current SIF regime. It would apply to all banks and bank holding companies ‘operating in the UK’. For banking groups headquartered outside the UK, it is not clear how this would work, but it appears that a UK SPR could not report to a UK non-SPR. It isn’t clear whether the SPR would apply to mutuals or other bank-like institutions.
(b) A new Licensing Regime - based on a revised set of Banking Standards Rules and applying to more staff than the current Statements of Principles. These measures would be backed up with a reformed register of information on individuals. The Commission did not propose relying on professional standards body as an alternative solution, but it did recommend that the industry commence preliminary work immediately to establish a professional body to demonstrate its commitment. How this would affect the role of existing banking professional bodies fits remains unclear.
Anyone who can cause ‘serious harm the bank, its reputation or its customers’ would be caught by the new Licensing Regime. Customer facing roles, such as advisers in branches, could fall into this regime (which is currently a controlled function under the Financial Conduct Authority (FCA) regime, rather than the Prudential Regulation Authority (PRA)). The Licensing Regime would not require pre-approval by the regulator, instead relying on firms to verify fitness and proprietary of their staff. This approach is similar to the existing CF30 regime, where the firm makes an application for an individual to become an APR only after it has carried out sufficient due-diligence.
The Commission wants to do away with the existing Statements of Principles and codes of practice. They would be replaced by new Banking Standard Rules applicable to the Licensing Regime. Banks that have taken disciplinary action against staff for breaches would have to report that to the regulator, who would then assess whether further enforcement action was necessary. This information would all be stored on the strengthened register.
The regulators updated the APR and SIF regimes very recently. The PRA has already demonstrated a willingness to challenge and stop appointments of high-profile people and roles where it believes it is necessary. It is not clear whether these changes will bring about any real improvements in the recently updated system.
How would these changes affect other sectors? The current APR applies to asset managers, insurers and other authorised firms. The Commission sees a strong argument for applying these changes to other sectors as well as banks. Having several different systems operating could be confusing, especially where financial services professionals change jobs and move between industry sectors or where an individual has multiple hats in a group with non-banking activities.
Getting the new systems into alignment with EU measures will also pose challenges. The European Banking Authority has recently consulted on changes to the criteria of code staff caught in scope of the remuneration code; any new UK system must work in conjunction with these European requirements to avoid duplication for firms and regulators.
i. Sanctions and Enforcement
The Commission want future bank failures to be more clearly and fairly attributable, providing a stronger basis for sanctions and enforcement against individuals.
Acknowledging the recent increase in fines imposed by regulators, the Commission wants the PRA and FCA to review their penalty setting frameworks again. The Commission sees increased penalties as partly targeting shareholders, who should be incentivised to ensure better behaviours in the firm, but also individuals, with fines taken from deferred remuneration.
But the Commission goes even further in targeting individuals. It acknowledges the wider ranging but ‘rarely applied’ powers of disbarment, and fines, available to the current regulators. But in applying the Licensing Regime, the Commission wants more banking staff to be subject to these obligations. The SPR should provide regulators with a stronger basis for using their enforcement powers on individuals, even where those individuals have delegated certain responsibilities.
The Commission shied away from implementing a rebuttable presumption that directors of failed banks shouldn’t work in the industry again. Instead it proposed a ‘reverse burden of proof’ for a wider set of conduct and prudential failings. If certain conditions are met, the regulators would be able to impose the full range of civil sanctions on an individual unless that person could demonstrate that they took all reasonable steps to prevent or mitigate the effects of a specified failing. The regulator would not be bound by the three year time limit in certain cases.
The Commission recommends creating a new criminal offence of ‘reckless misconduct in the management of a bank’ for severe failings. The offence would apply to all persons caught under the SPR, and would carry potential custodial sentences for the most serious cases. The Commission also calls for individuals who have been found guilty of reckless mismanagement of a bank to disgorge some of their past remuneration payments.
The implications of these changes remain to be seen. While the new regulators are already developing and understanding their new powers, further changes will add to the burden on individuals. Clearly individual responsibility is important in firms; but a balance between responsibility and retaining an industry which is appealing to applicants is critical. The cocktail of measures increasing individual accountability may make the banking sector a less attractive place to work. Attracting good people to the banking sector is crucial to ensuring that individual banks are well-run and to maintaining London as a pre-eminent financial centre.
Focusing on individual responsibly, the Commission makes a number of recommendations in relation to remuneration that go beyond existing regulation. It does not believe that ‘crude’ bonus caps are effective, but concludes that variable remuneration needs reform. The Commission’s view on the role of pay is clear: “remuneration lies at the heart of some of banks’ biggest problems.”
The recommendations are, for the most part, sensible and the Commission has largely avoided headline grabbing but unworkable proposals. But focusing on the structure of remuneration is unlikely in itself to achieve the culture change that the Commission is looking for.
The Commission has identified high pay as one of the key issues affecting public confidence in the banking sector. Bankers are perceived as having received huge rewards which in many cases bore no relationship to the work done or the performance achieved.
The Commission identifies two key themes:
For our full analysis of the remuneration elements of the report, please see our Risk and Reward publication.Back to top
The Commission considered many aspects of governance, from the specific responsibilities of shareholders and the board of directors through to more nebulous concerns about the pervading culture within banks and their attitude towards whistleblowers.
Since the 1970s, bank ownership has moved away from individual shareholders towards large institutional shareholdings. The Commission blames institutional shareholders for failing to interact with the banks in most circumstances and for not exercising the control expected of shareholders. Where shareholders have intervened, they have typically applied pressure on the banks to take on additional risk and increase leverage to boost equity returns.
The Commission concludes that institutional investors themselves have incentives that are frequently at odds with the long-term interests of banks, the general public and, potentially, the beneficial owners of the shares. For example, some asset managers and similar investors are themselves rewarded for making short term gains rather than achieving long term growth. For that reason, the Commission believes it is unrealistic to expect greater shareholder empowerment to drive a profound and positive change in banks’ behaviour.
ii. Bank Boards
While generally corporate governance has improved in recent years, in banks it has been found wanting. Even banks which emerged from the financial crisis relatively unscathed face some criticism. The Commission observes that “the corporate governance of large banks was characterised by the creation of Potemkin villages to give the appearance of effective control and oversight, without the reality.” It singles out the inability of non-executive directors to challenge the executive adequately as a particular cause for concern.
The Commission does not believe that governance failings can be addressed by either “a quick single fix” or “a great many recommendations ... which may do nothing more than create yet more lucrative work for corporate governance professionals”. The solution is to enhance personal responsibility. Some of this responsibility agenda is addressed by the proposed SPR regime noted previously. Specific individual governance responsibilities include the following:
In theory, banks may not find implementing these recommendations onerous, but they certainly create new personal risks for senior management. Requiring individuals on the board to accept personal responsibility for board awareness of risk and compliance concerns won’t ensure that those concerns are raised appropriately in the first place. It also pre-supposes that those individual board members will have the ability to sway the views of their fellow directors. While having well designed procedures for whistle-blowing is clearly a part of good governance, many potential whistle-blowers may still be reluctant to trust in the protection of a distant figure on the board. Would a non-executive director really be best placed to respond quickly if a whistle-blower is experiencing repercussions?
The Commission’s recommendation that directors have a duty to put financial stability ahead of shareholders’ interest is worth consideration. Arguably, ensuring a bank’s long-term financial stability should ultimately be in the shareholders’ interests. But the Commission acknowledges that institutional shareholders will still need to place pressure on directors to improve short-term returns, and those shareholders retain the ability to replace senior management if those returns don’t materialise. If the board is obliged to place other financial stability considerations above shareholder concerns then it may need protection from those shareholders.Back to top
The Commission believes that effective market discipline, geared to the needs of consumers, is a better mechanism for improving standards and preventing consumer detriment than regulation.
But worries over Government’s implicit state guarantee of banks that are “too big to fail” that arose from bailing out banks during the financial crisis continue to cause tension whenever measures to improve competition are mooted. Existing market forces are not imposing sufficient discipline on UK banks to reduce prices and improve services. The retail banking market is highly concentrated, with substantial barriers to entry. Even measures such as the privatising Lloyds and the RBS, market reforms like the new 7-day account switching service and the establishment of a pro-competition FCA are unlikely to stimulate competition in the medium term.
To move forward on competition, the Commission wants the Competition and Markets Authority to get going on a market study of the retail and SME banking sector, with a full public consultation on the extent of competition and its impact on consumers. They also want the PRA to get a new competition objective.
The seven-day account switching service, if adequately promoted, should improve the switching process for consumers and increase competition. However, the Commission is still calling on the Government to look at account portability, to enable consumers to take their account numbers and sort codes with them when they changed banks.
The Commission believes that concerns about challenger banks have largely been addressed by earlier efforts to bring down barriers to entry and overhaul the authorisation process. But the Commission notes that regulatory authorities have displayed “an instinctive resistance to new entrants” in the past, particularly those with unorthodox business models. Diversity, which the UK market lacks, can increase competition and choice for consumers and make the financial system more robust by broadening the range of business models in the market. In particular, the Commission points to the potential of peer-to-peer and crowdfunding platforms and calls on the regulators to ensure that these non-traditional funding mechanisms are not put at a disadvantage. This initiative to open up competition also should apply to non-banks engaging in the credit intermediation process—although the report barely touches on this sector. Regulation of alternative providers must be appropriate and proportionate and must not create regulatory barriers to entry or growth. The Commission also wants the Government to examine the merits of requiring the large banks to relinquish ownership of the payments system by the end of the year.
We welcome the Commission’s gusto in promoting competition in the banking system, but not all competition is good. In the run-up to the financial crisis, competition resulted in unsustainably low interest rates as banks battled for market share. To make up for cost in providing these loans, banks sold highly profitable but inappropriate insurance products.
Competition is only good for customers when it produces sufficiently differentiated choice, transparency on value, and no perceived or real obstacles to changing products.Back to top
The Commission cites “serious regulatory failings” as contributing to the fall in banking standards. It found that the FSA was too focused on detailed rules and processes and insufficiently aware of bigger picture problems. When problems were identified, such as with PPI mis-selling, it was slow to respond, allowing the problem to grow.
The Commission’s specific recommendations for regulators closely follow the new approaches already being put into action by the FCA and PRA, including bringing in more forward looking regulation, greater focus on the judgement of senior staff at the regulator, and the power for regulators to intervene at short notice where problems are identified with particular products.
The Commission also sees auditors taking a wider role - engaging more directly with regulators and signing off on banks’ regulatory returns as well as their statutory accounts. The only really new tool that the Commission suggests is “special measures” for the PRA and FCA to use when they believe that a bank’s failings in leadership, risk management and control are making it prone to “standards failure”. It suggests that this tool could be used as a precursor to enforcement activity, to instruct the firm to make certain changes to their practices. Some in the industry will see similarity to existing ‘Skilled Persons’ activity in the proposal.
The FCA and the PRA appear to have already implemented many of the recommendations in this part of the report. Are new “special measures” really necessary, when existing legislation already gives the regulators significant powers to intervene where they believe a bank is not meeting required standards? If the forward-looking, proactive regulatory approach recommended by the Commission, which the FCA and the PRA are already adopting is effective, it is hard to see why the regulators need further emergency intervention powers given their existing tools.Back to top
Firms need to consider now what the Commission’s recommendations may mean for them. Far-reaching changes to existing legislation and some new legislation will be required to enact these changes, if the Government accepts the recommendations. But David Cameron, speaking at Prime Minister's Questions this week, indicated that he wants to include some of these changes in the Financial Services (Banking Reform) Bill, which has reached report stage in the House of Commons. This approach could mean some recommendations would be implemented rapidly - including the measures relating to the ten year deferment of bonuses, and the creation of 'reckless mismanagement' offence. Some recommendations might be adopted by the regulators under their existing powers. Others are likely to require further consideration before new legislation can be introduced.Back to top
Five years on, we are still learning the lessons from the financial crisis. The banking industry remains deeply out of favour, and clearly still has much more hard work ahead to rebuild trust with the public. This debate will continue until the Government privatises the taxpayer-owned banks, and satisfactorily addresses the moral hazards arising from implicit state financial guarantees of financial institutions.
The Commission’s report is yet another milestone on the journey to recovering from the financial crisis, as we seek to better manage financial stability risks and rebuild trust between the public and the financial institutions who serve them. It is not the end of the journey, but perhaps the Commission has at least fully aired many of the issues that must be addressed to establish a well-regulated banking industry that customers can trust.Back to top