Andrew Bailey: Progress on prudential regulation and three areas to
complete
Speech by Mr Andrew Bailey, Deputy Governor of Prudential Regulation and Chief Executive
Officer of the Prudential Regulation Authority at the Bank of England, at the City Banquet,
Mansion House, London, 22 October 2015.
* * *
My Lord Mayor, Ladies and Gentlemen - it is a great pleasure to be here again at the regulators
dinner, and it is very good of you to entice so many people here tonight with the prospect of
an evening with regulators. I won't speculate on how this ranks on the scale of evenings spent
in our cosmopolitan capital city. It is also a great pleasure to be speaking here tonight with
Tracey.
This evening I want to describe the progress we have made on prudential regulation and then
examine a number of topical issues for the PRA and the Financial Services industry: the Senior
Managers and Certification Regime; structural reform and ring fencing; and what the PRA is
doing to pursue its secondary objective on competition. A common theme here is getting the
incentives right to support good outcomes in relation to both prudential and conduct objectives.
Progress
It is over eight years now since the financial crisis began in this country. And to continue
Tracey's theme for a moment, it is possibly salutary to recall that amidst the many bad events
of Autumn 2007, England reached the Final of the Rugby World Cup. I didn't expect to say
"those were the days" about 2007. It was natural that the first response to the financial crisis
in terms of reforms was focused on the bedrock prudential issues of capital and liquidity in
banks. This has been supplemented by the drive both internationally and domestically to solve
the too big to fail problem through a combination of resolution measures at the centre of which
is agreement on total loss absorbing capacity for those banks which require such a bulwark to
ensure orderly resolution in the event of failure. This is crucial to break the dependence of
failing banks on injections of public money and likewise to break the impact of solvency
problems in banks on the public finances.
This is an international as well as domestic agenda of reforms aimed at fixing the fault lines
that caused the financial crisis, building a more resilient and open global financial system, and
deepening and building trust across jurisdictions. I have said before, but I think it justifies
repeating, that we are unwavering supporters of an open global financial system which
finances the investment and trade necessary to support strong, sustainable and balanced
growth. As we see and seek to deal with new risks to the world economy and to global financial
stability it is always important to remember that free trade and free capital flows are the
foundation of a successful world economy with all the benefits that brings for the welfare of
people.
So, it should be no surprise that our focus is on three things: first, full, consistent and prompt
implementation of the already agreed reforms across the financial system, and here I would
note that the largest single activity for the PRA this year is to complete the implementation of
Solvency 2 for insurers for the end of this year, something I believe we are on course to do;
secondly, finalising the design of the remaining post-crisis reforms and thus providing the much
needed clarity around the future regulatory system; and thirdly, scanning the horizon for new
risks and vulnerabilities that appear on our landscape, ones such as the risk of cyber
disruption.
I think there is solid evidence of progress in all of these three areas. Internationally, there is
plenty of evidence of shared objectives and effective co-operation among national authorities
to solve common problems and "own" and thus implement the resulting reforms. An example
over the last year has been the building of strong working relations between the PRA and our
colleagues at the Single Supervisory Mechanism of the ECB. This can only be for the good,
and represents the much needed close working of people who are on the front line supervising
the system.
We also want to encourage sound market-based finance and we are, for example, strong
supporters of the EU initiative on simple, transparent and standardised securitisation.
Finalising design
When I look at the remaining agenda of post-crisis reforms to be agreed, it is striking that they
are not about capital levels in the same way that we saw immediately post-crisis. True, there
is work in Basel but that is much more about refining the framework than a step change in
capital requirements. As part of this there is work to agree and implement the leverage ratio
internationally, and to improve the use of models to estimate capital requirements so that they
are used only for asset classes that lend themselves to modelling of this sort and we have an
acceptable degree of consistency across banks.
There are two important points I want to draw out which are by no means uncontroversial.
First, it is sometimes said that the banking system still needs markedly more capital, and that
a focus on other issues is a distraction from tackling a system that is still over-leveraged. The
second, closely-related, point is that we should focus much more exclusively on non-risk based
measures of capital requirements.
I don't agree with either of these positions, and nor would I say do most supervisors I know. I
have been and remain a strong supporter of the reforms to date and the higher levels of capital
put in place, and I am a strong supporter of having the leverage ratio in our toolkit and that for
some assets it is the "biting" approach and therefore it is not just a backstop. But I disagree
with those who want to go much further, for reasons which are at the heart of what we are
doing.
First, because to argue for much higher capital on top of what has been done since the crisis
is to argue that what is being done on resolution and loss absorbency is of little use. This
misses the point that resolution is about being able to stabilise and then where necessary close
or restructure failing banks. In other words, resolution is a much more extensive approach, and
in my view very necessary. The design of international policy measures to end too big to fail is
now largely complete for banks, but substantial work remains to put these into effect in terms
of resolution plans.
Second, understanding how banks take and manage risk, the controls they have and the
quality of risk management, is at the heart of the job of a prudential supervisor. That's what we
do every day, and the standards of this work have been raised extensively since the crisis,
which was very necessary. Now, it is possible I suppose to argue that a focus on oversight of
risk management should be pursued alongside a sole focus on a non-risk based capital
measure like the leverage ratio. But in my view that is a flawed argument because the
prevailing capital regime has a strong influence on how firms take and manage risk, in other
words it creates the incentives. And, if we only used a non-risk based system, we would
incentivise firms to disregard the amount of risk per unit of assets on their balance sheet. The
leverage ratio is firmly in the camp of necessary but not sufficient, as is the risk-based
approach.
The third reason why I disagree with the much more capital school of thought is because there
are more important things for us to do, which revolve around getting the incentives for
behaviour right in firms. This is why as supervisors, both prudential and conduct, we spend so
much time on governance in firms and on getting the incentives aligned for individuals through
our approach to remuneration and to the responsibility of individuals.
We have achieved much progress towards strengthening the resilience of the global banking
system, with stronger capital ratios, and this has demonstrated in my view the important
principle that appropriately strong capital positions support rather than deter lending by banks.
Jobs still to finish: three topical issues
The Senior Managers Regime
The Senior Managers and Certification regime for banks is a product of the Parliamentary
Commission on Banking Standards chaired by Andrew Tyrie, put into legislation and to be
implemented by the PRA and FCA by next March, so not long to go now. The current approved
persons regime has not delivered effective incentives and thus behaviour.
As part of last week's announcement on the Bank of England and Financial Services Bill, the
Government put forward an important change to the senior managers regime for banks, by
removing the "presumption of responsibility" and replacing it with a "duty of responsibility". I
can tell you from my postbox in all its many forms, that the "presumption" is the most
controversial element of the new regime. On its own that is not a good reason for change. I
want therefore to explain why the change does make sense, and why the new regime should
create the right incentives.
In the current Approved Persons regime, the PRA and FCA can take formal action for
misconduct against an approved person either if that person has failed to comply with the
statements of principle (which will become in the new regime common rules of professional
conduct) or they have been knowingly concerned in a breach of a regulatory requirement by
the firm. The burden of proof in an enforcement action falls on the regulator.
The Banking Reform Act adds a third reason to take enforcement action against senior
managers (not others) in these firms if: the firm (and I emphasise here the firm - going beyond
the individual) has breached regulatory requirements; and the senior manager is responsible
for the area of the firm in which the breach occurred. The Act goes on to say that the person
would not be guilty of misconduct if they satisfy the Regulator that they have taken such steps
a person in that position could reasonably be expected to take to prevent the breach. For the
first two limbs the burden of proof would fall on the Regulator in the same way as the continuing
provisions I mentioned earlier. But, crucially, it would be for the senior manager to satisfy the
Regulator on the question of reasonableness - thus the presumption is created until it is
rebutted. The change that the Government has announced to create "the duty of responsibility"
will, if Parliament approves it, replace the presumption with a statutory duty on senior
managers to take reasonable steps to prevent breaches of regulatory requirements by their
firms from occurring. Thus it will be for the Regulator to show that the senior manager did not
take such steps as it was reasonable for a person in that position to take to prevent the breach
of regulatory requirements.
In my view this does not represent a watering down of the requirement. Why? Well the "duty
of responsibility" creates a positive duty on senior managers to take reasonable steps to
prevent regulatory breaches occurring. This will be on a statutory footing, which hardwires the
concept in the very fabric of the regulatory regime, rightly reflecting the importance which
society places on this issue.
Let me be very clear, substituting "duty" for "presumption" changes the mechanism of
enforcement not the substance of the requirement on senior managers, and I would not support
changing the latter. There has been a lot of noise around the new regime in recent months,
and I have asked people involved whether their problem was with the "presumption", or with
the regime more broadly. The universal answer has been that the difficulty was with the
"presumption" not the regime which appears to have broad support.
So, if Parliament is in agreement, and I do not presume to take that for granted, I expect that
the new regime will be put into effect in the spirit with which it is intended, and that the focus
will shift to that spirit and away from finding ways to circumvent the "presumption". To be blunt,
I hope that those within firms and their advisors will respect the will of Parliament on this crucial
point.
The new regime matters hugely for getting the right incentives for people running firms. The
important word is not "presumption" or "duty but rather "responsibility", it's about holding people
more personally to account. If there are people who wish to argue that they should not take on
the responsibilities of the job they do, then I believe they have no place in the industry, it's that
simple. We all want well-run firms where senior people lead and take responsibility. And I know
that this is how the vast majority of people do behave, because I observe it.
The senior managers and certified persons regime is also not purely, or in my view even
primarily, a tool of enforcement. Our job is always to apply forward-looking judgement to
prevent problems occurring; and the new regime will ensure that the incentives on senior
managers in the roles that they perform align with that approach. But, just as Parliament has
recognised that it is not the PRA's role to ensure that no firm fails, likewise we should not
expect the Regulators to prevent all failures, or misconduct, by individuals. The PRA's
enforcement powers are a necessary part of its toolkit, and we will use those tools when the
circumstances warrant it. But they are not our primary mode of operating. Also, the
Government announced last week that - subject to agreement by Parliament - it plans to
extend the Senior Managers regime to other firms across the industry. This is a further step in
the right direction. There is no doubt that one regime will be better than many.
Lastly on the senior managers regime, there is one other very important broad reason for
putting it into place. On and off I have been involved in regulation for over twenty five years.
During that time a few regimes have come and gone, and there have been debates about
selfregulation versus a regime more purely in the hands of public authorities. This debate strikes
me as a gross over-simplification. Self-regulation doesn't work if there is no clear and
consistent allocation of responsibility for the public interest objectives of financial regulation to
public bodies that are answerable to the government and to parliament. But likewise, public
bodies cannot seek to take on the responsibility of managing within firms, something that has
to be the responsibility of boards and management. The senior managers and certification
regime is vital here because it creates the framework to establish effective responsibility within
firms, while maintaining the role of the public authorities, the PRA and FCA, for supervising
and enforcing the public interest. A very good example of how this should work can be seen in
the recommendations of the Fair and Effective Markets Review, which provide a means to
establish and maintain high conduct standards in financial markets.
Structural reform
I want now to turn to structural reform and ring fencing. This is a subject in its own right, but I
can assure you that I intend to be brief on this one tonight. We are now well into
implementation. Last week we issued our second consultation paper on implementing the
regime, and we plan one more such paper which will be more in the form of a wrap up of points
raised and a few outstanding actions.
Any structural reform measure involves complex implementation, the devil is always in the
detail, and we need to get that right. I read from time to time that we are apparently watering
the regime down via the implementation. I can assure you that we are not doing so, and we
should not because that would go against the will of Parliament. But, sensibly, the regime
sensibly allows for a degree of flexibility in how the requirements are implemented, recognising
the differences in business models, legal structure and strategy of various firms. That was
essential and sensible because a rigid definition of the fence would not work well for all firms.
To ensure balance, I should say that I also get the opposite commentary, that the
implementation is too rigid. One particular form of this commentary is that our rules on the
governance of the ring fenced bank within a group mean that it will be independent in all
respects, and that, proverbially, it will be able to stick two fingers up at its parent. No. The ring
fenced bank will have to observe the law in respect of the requirements of ring fencing, not
more than that. This is not really different from the position for banks that have subsidiaries
operating in other countries, they have to respect the laws of the country in which they operate.
But, let me be clear what it does not mean: it does not mean that the ring fenced bank can set
its own strategy and thereby ignore the group to which it belongs; it does not mean that it can
set its risk appetite in isolation of the group to which is belongs; it does not mean that it can
refuse to pay a dividend to its parent if it is adequately capitalised both now and looking
forwards using stress tests (in other words, it does not have a reason to trap excess capital);
and it does not mean that its CEO can ignore the Group CEO. But, and this is crucial, the group
cannot require the ring fenced bank to break the rules of ring fencing. I hope this is clear. If
you think we have watered down the regime, please let me know.
Competition
I want to finish on an equally important subject, namely competition in the banking industry,
which is of course topical today in view of the CMA's report. The PRA has been given by
Parliament a so-called secondary objective which I think is best described as requiring us to
act in respect of the competitive implications of our own actions and inactions but only to the
extent that we are not undermining our primary objective for banks of safety and soundness.
We have been working to embed the secondary objective in the PRA, and to date our most
publicised actions have been in the area of new bank authorisations. The PRA has authorised
ten banks in the last two years, and currently we have a substantial pipeline of interested
parties.
We are thinking about competition in our domestic work, but also about how we approach
international policy issues. For instance, this week our response to the European
Commission's consultation on the impact of the new capital regime has been published. It is
quite often said that aspects of the capital regime discriminate against smaller banks and
building societies that use the so-called standardised capital approach versus larger banks
that use their own models. The consequence of this is that smaller banks and building societies
cannot compete effectively in lower risk asset markets such as prime mortgages because the
capital requirements are too far apart and in favour of large banks. This forces them into riskier
assets and undermines their position.
This is an area where the leverage ratio acts to counterbalance the difference, a point that is
not well enough understood. But in our response to the European Commission we said that
while the financial stability benefits from regulation of large, internationally-active banks mean
these firms should meet global standards, a differentiated approach for smaller firms would
recognise the high costs and smaller benefits of applying global standards to them, and should
enable us to find ways to create a regime which is more simple and which reduces their
reporting burden. This would help to foster competition and would be good for the European
Single Market. This is an important issue, and one that matters if we are to have growing
challenger banks. We want to put such a regime into effect, and thus demonstrate that at the
PRA we are very serious about our competition objective. I hope the European authorities will
likewise pursue this important change.
We will also be arguing in Basel and in the EU to narrow the gap between standardised and
internally modelled capital requirements for prime mortgages including by having more risk
sensitivity in the standardised approach. And, we have also tightened the standard for models.
I also want to be clear that we welcome internal model applications by smaller banks and we
will do what we can to help them meet the required prudential standards, which are largely set
out in the EU legislation.
Lord Mayor, a year in your office is never dull, and likewise our world is certainly full of interest.
I have ranged quite widely this evening to give a report on a number of our key areas of activity.
There are however some very important core principles at the heart of our work, getting the
incentives right for firms and individuals, and establishing the importance of personal
responsibility within an appropriate setting. I have been blunt on one or two points and this
may provoke debate. This is a good thing, and we will have the opportunity to return to the
debate on these issues at The Open Forum being organised at the Guildhall on November
11th. I know you will be there, as will Tracey and I. Please, will everyone participate, and to
find out more consult the Bank of England website. Thank you.