UK financial regulatory consolidated

by

SALLY RAMAGE

2005

The subject of centralisation of financial regulation has been studied for dozens of years . There have been fears that consolidated and centralised financial regulation will mean consolidated international governance. Countries such as the UK have a market-based financial system others have a bank-based system with goals, structures and operations that differ. There are real costs involved in regulating financial systems namely, the capital costs, labour costs, technological costs, training costs and not least the opportunity losses. The Paper examines the newly consolidated UK financial regulatory system and questions whether it can be successfully used as a model for developing countries. It concentrates on the banking system , this being the most important part in facilitating terrorism, money laundering, arms, drugs and people trafficking, the black economy and trans-national crime generally. It is assumed that the main reason for regularising and regulating countries' financial systems is to stop the exponential explosion of serious fraud which has recently been facilitated by the rapid development of electronic communications. Since fraud has been shown to rise exponentially with the growth and wealth of a country, fraud will not be curtailed. The other main reason for the furious drive to consolidation and regularization of all countries’ financial systems must be the actual technology itself; computerisation is driving consolidation and uniformity. We now have the “MACDONALD - isation” of the world’s financial systems. This aim for uniformity and standardisation does not suit all countries and many will struggle to cope. The aim for global economic stability and international security through transparency and accountability is a valid aim but the writer argues, this aim and consolidation, centralisation and regularisation, are mutually exclusive.

INTRODUCTION - The UK Financial System

Since 1997, the UK has reformed its financial system by separating its banking supervision from the operation of monetary policy by creating the Financial Services Authority, a single regulator that covers banking, securities and insurance. This regulator is independent from the Bank of England and therefore independent from the government. The Bank of England has clear responsibility for operating monetary policy whilst the Financial Services Authority is responsible for financial services regulation. There is a Debt Management Office which is responsible for the government's debt management policy.

The UK has 2 rules for government in that over the economic cycle the government can borrow only to invest and not to fund current spending; the other rule is that the net government debt will be maintained below 40% of GDP over the economic cycle.

We will examine the system's results to see if it has achieved its goal of increased openness and transparency, price stability, long term policy predictability, translated into economies of scale, simplicity, prevention of regulatory arbitrage, accountability, reduced costs and improved policy co-ordination.

The Financial Services Authority

The government through the Treasury retains responsibility for the overall institutional structure of the country's financial services regulation. and for the legislation which governs it. It sets the FSA's long-term policy objectives but the FSA has operational responsibility for delivering these objectives.

The FSA is a private company which discharges a public function and has regulatory powers through statute. It does not rely on government for its funding, but levies fees on the firms it regulates and uses this to cover its costs. It reports annually and must confer if it changes its fee structure. The FSA regulates banks, shares and insurance. It makes rules by which it supervises institutions and firms are bound by them by law.

The FSA makes an annual report to the Treasury. The Treasury can initiate reviews of the FSA and so can the DTI. The FSA has a single enforcement regime applicable to all the firms and individuals it regulates. It has a risk-focussed, authorisation process applicable across all sectors. The FSA also supervises the London Clearing House and CREST, securities clearing and settlement systems

The UK's Debt Management Office (DMO)

The DMO is an executive agency of the Treasury. It is responsible for the government cash -flows and operates in line with the International Monetary Fund and the World Bank. The UK has a low level of government debt. The IMF regularly investigates countries financial systems for weaknesses and reports on its findings. In June 2003 the IMF reported in its Financial Stability Assessment Programme, that the UK's banks are well capitalised and profitable and have a low rate of non-performing loans. The IMF found that the UK has a high-quality accounting and disclosure regime. The insurance sector however did not reach some internationally agreed framework with a great disparity between the insurance sector and the rest of the financial industry. Under the Financial Services and Markets Act 2000, it is now a criminal offence to conduct insurance business without authorisation by the FSA.

What constitutes a 'contract of insurance' is not defined by law although the FSA has put out guidelines to be enforced from1^st January 2005 when it takes over the supervision and regulation of the UK insurance sector.

The Payments and Settlements Systems

The Bank of England is responsible for these systems. The main payments system is CHAPS or Clearing House Automated Payment System. The retail payments system is the BACS or Bankers Automated Clearing System. There are also the Cheque and Credit Clearing, debit and credit cards and LINK Interchange Network Limited.

Outside Forces

Apart from the IMF and the World Bank, there is the Basle II Capital Adequacy Revisions, the EU Risk-Based Capital Directive, the Solvency Directive and the Re-insurance Directive with which the UK must comply, the objectives of which are global economic stability and international security.

The EU's efforts at regional security

The regional integration among the member states of the European Union (EU) can be viewed as the functional harmonisation of national laws. Beginning with Article 100 of the Treaty of Rome in 1958, Member States of the EU harmonised nearly 200 of their laws, regulations and administrative provisions ij the areas of taxation, social policy, transportation, and the environment. This is not total harmonisation but an effort to assimilate as much legislation without each state losing its jurisdiction, a sort of national convergence by adopting similar legislation which is separately enforceable in each state. As much as 60% of member state legislation is derived from the EU and is directed mainly at trade and harmonising legislation is a way of achieving policy congruence without walking over national sovereignty.

The EU is highly integrated into the international financial system. It is this integration together with highly developed technological computerised systems that calls for even greater security from risks such as international crime, insider dealing, money laundering and other monetary frauds. The EU' has a huge interest in the regulating and supervision of banking and need centralised regulatory systems to prevent systemic risk.

There have been a series of Concordats of the Basle Committee on Banking Regulation and Supervisory Practices known as the Basle Committee. This is an informal consultative group under the auspices of the Bank for International Settlements at Basle, Switzerland with representatives of the central banks of Belgium, Canada, France, Germany, UK, Italy as committee members. In 1992 there was the EU Directive 92/30 on the Supervision of Credit Institutions on a Consolidated Basis. The most recent harmonisation step is the Basel Accord aimed at consolidation of the banking system through supervision, capital requirements, securitisation rules. The Basle Accord is a plan to recast some past EU Directives between 1993and 2000 because it recognised a wider range of credit risks and seeks to put regulation in place by 31 December 2007 to mitigate these risks.

The most readily admitted risk to the EU financial system is acknowledged as the denationalisation of money which passes from one territory to another through banks' payment systems regulated by divergent national laws. For example, the point of payment in the UK law is the point at which the funds are transferred by the recipient bank into the payee's account. Most European member states except the UK have laws which state that the point of transfer is the point when it reaches the recipient bank. There is no agreement moreover, of what law applies when different currencies are involved in a transaction. Since there is no clear authority, trans-national currency is unregulated internationally which have important implications for banking transactions but not for banking risks.

Surveys of banking news and regulatory literature show that the most important risk in banking is imprudent lending especially credit risk and security risk, even in the modern electronic age. The collapse of one large bank due to no liquidity can have major repercussions in the international financial system. It is the illiquidity that is the risk and the electronic speed of news, transactions and market trading only increase the danger of financial instability transmitted instantly and globally. This was recognised by the First Basle Accord in 1983, reacting to the 1975 failure of the Bankhaus Herstatt and the failure of Banco Ambrosiano in 1982. The Committee on Banking Regulations and Supervisory Practices issued a Revised Basle Concordant, Principles, for the Supervision of Banks' Foreign Establishments, International Legal Materials. There followed the 1988 Basle Capital Adequacy Accord in an attempt to protect the EU against risks from American under-capitalised banks. Following the UK's Bank of Credit and Commerce International (BCCI) collapse, the Minimum Standards for the Supervision of International Banking Groups and their Cross-Border Establishments was put in force in 1992. The Minimum Standards were that all international banks and banking groups should be supervised by a home country regulator; there should be prior consent from the host country and from the group's home country before creating a cross-border bank; supervisory authorities should be able to investigate and collate information about the bank; and the home country authority can impose restrictive measures consistent with these minimum standards before such a cross border bank can be established. By 1995 75% of the Euro-markets consisted of US dollars and competition among member states increased creating arbitrage and laxity in regulatory systems. Indeed, the available global portfolio has 80% invested in the US, UK, France, Germany , Canada, Hong Kong, Switzerland and the Netherlands, making a study of EU and US banking regulations essential to combating money laundering. Since most of global money passes through these developed countries, it is logical to expect that it is in these countries that significant fraud will occur and therefore it is these countries that need stringent implementation of anti-fraud systems, not the small developing countries. A comparison of one of these systems such as the UK's with African economies or Latin American economies will reveal the huge differences in systems and might allow us to discover why fraud is increasing despite good regulatory systems, what aspects of regulatory systems are actually working and should be implemented in developing countries, what intangible processes do work and so should be implemented and whether unrecorded and undiscovered factors play a role in the exponential increase in financial fraud .

A new regime replaced the 1988 Basle Capital Adequacy Accord in June 2004 and has 31 December 2007 as the due implementation date. The Basle II was necessary because there are still significant issues in the EU banking system, these being intra-group exposures, supervision, and scope of consolidation, supervisory co-operation and credit risk mitigation. The 2004 Basle II replaces the 1988 Capital Accord and its corresponding EU directives on capital adequacy. The capital adequacy rules of 1988 have been proved to be ineffective and the new capital adequacy will involve more sophisticated, risk-sensitive calculation of capital requirements, a choice in ratings indicators, basic, standardised and advanced measurements, a new specific component for operational risk, a new framework for securitisation and broader, more sophisticated recognition of credit risk mitigation. It also includes changes to the trading book regime. The directive to implement the Basle II has three levels, 160 Articles open to amendment only be legislation, 14 Annexes open to amendment only by the European Banking Committee and an ongoing scrutiny by the Committee of European Banking Supervision.

For the UK, the Basle II Accord will bring huge differences in its intra-group exposures which, at present, attach zero % risk to intra-group transactions, ignoring even the 1988 Basle Accord on capital adequacy!! There will be extreme consequences for the UK when it is forced to implement capital adequacy regime The 2004 Basle II Accord has only few exemptions to capital adequacy for intra-group concerns , as per the 2000/12/EC/Article 80,7. These exemptions are only for a type of firm within the same consolidation, within the same risk management, in the same member state. Some UK banks have Channel Island subsidiaries which will have to comply. Because supervisory review will be of a firm's whole risk profile, it will represent one supervisory review for the whole of the EU.

The legal issues with regard to credit risk mitigation include identification of relevant jurisdictions - what is the governing law of agreement?; which is the jurisdiction of incorporation?; which is the jurisdiction of any branch?; are there any EU counter-parties?; which is the relevant jurisdiction for collateral?; what are the conflicts rules in respect of these jurisdictions?; where are the physical collateral such as gold or commodities located?; where is the financial intermediary located?; who will monitor implementations?.

The present forces that drive the harmonisation of banking regulation

Fraud, money laundering and corruption and the information technology revolution are the other major drivers in harmonisation. These are threats to the international financial system.

Developing Countries' Financial Regulatory Systems in view of Issues in the UK Financial Regulatory System

(a) The UK's Consolidated Financial Regulator, the Financial Services Authority (FSA) is an independent limited company.

Financial sector supervision is more rigorous than other regulated sectors because they manage the health of the banks, preserve the stability of the financial system, protect consumers, and prevent market collapse. Weak supervision, ineffective regulation and political interference have been stated as factors for financial collapse by finance writers. Some examples of countries which faced collapse due to these factors are Korea, Indonesia, Japan and Venezuela

Contrary to such countries, those with independent regulators have wide autonomy in setting rules and regulations in order to achieve their goals. Supervisory integrity is crucial to regulation and in some countries legal protection is offered to supervisors.

Budget independence is also crucial if supervisors must be free from political pressures and must be able to build up funds. The UK is one step ahead in that the UK's FSA also has independence from its central bank, the Bank of England. There must be no conflict of interest. The key to effective independence is accountability and the FSA is in an ideal position for this because it is an independent limited company and must submit its accounts to the Treasury. And filed accounts at Companies House. Like all other such limited companies the FSA will have to provide a clear public statement of its objectives in cases of emergency the override mechanisms must be stated clearly.

(b) The UK is a liberalised economy with mature financial markets

The liberalisation of capital markets in the UK has been extensive and has taken place over a long period of time. Exchange controls were abolished in 197 and direct controls dismantled soon after that. Indirect controls on bank lending were removed, and bank reserves were no longer required. Controls on mortgages and consumer credit were relaxed. The securities market was deregulated. From the 1980's there was a shift away from self-regulation in the banking and securities sectors towards statutory regulation. There was the Financial Services Act 1986. The banking sector was supervised by the Bank of England. There was already statutory regulation of the insurance and building society sectors before 1979. Since the 1980's when home ownership became widespread, financial scandals impacted directly on the consumer and there was a public call for reform of self-regulation.

Since 1997, the Bank of England is responsible for regulating monetary policy and the new Financial Services Authority (FSA) is responsible for financial services regulation. A Debt Management Service is responsible for the UK Government's debt management policy. The UK had weak monetary and financial policy up to the year 1997 and was ineffective in financial regulation. So a new economic framework was established.

It is hoped that a consolidated financial regulator will bring economies of scale, simplicity, prevention of regulatory arbitrage, accountability and administrative co-ordination. There is no mention of fraud, even though fraud has been rising each year and was estimated at £40 billion in 2003.

To achieve these aims the single regulator was created to be independent, incorporated and self funding. The 2000 Financial Services and Markets Act which came into force in November 2001 gave the FSA powers to sanction, regulate, fine and investigate; the Treasury conducts independent performance reviews of the FSA, there is a Financial Services Practitioner Panel and a Consumer Panel, and a Complaints Commissioner. The FSA has uniform investigatory processes for all sections it supervises. The UK was the first country to be assessed against the OECD Money Laundering Code in 2003 the only shortfall found was in the insurance industry.

(c) The planned UK Markets Abuse Act 2005 will make whistle blowing by employees compulsory. This is taking heed of many analyses and studies which reveal that it is not the regulatory systems but whistle blowing that is the most used means of discovering corporate fraud.

(d) The UK already has witness protection measures in place in its legal system. There are also new protection measures in place for victims of traffickers. Section 51 of the Criminal Justice and Public Order Act 1994 created two new offences of intimidating a witness and harming or threatening to harm a witness.

(e) The UK has informally put in place the OECD Corporate Governance Rules

Corporate governance best practice is self-regulated in the UK. An industry-wide Working Party was set up to improve the reporting of Corporate and Social Responsibility and Corporate Governance and concluded that there is a need for a more efficient and open approach to the means of reporting such information between listed companies. Since September 2004, there is a new Corporate Responsibility Exchange (CRE), an online disclosure tool for listed companies to report voluntarily.

The Developing Countries Financial Situation

How far away are the developing countries from financial regulatory consolidation with regard to banking? All these countries have a single bank regulator, being the country's Central Bank, except India and the Maldives which have an independent supervisory agency (Appendix 1). Total bank assets represented as a percentage of Gross Domestic Product is a good measure of the size of a country's banking industry and Malaysia, Malta, New Zealand and Vanuatu have bank-based financial systems

(Appendix 2).

As to government ownership of bank assets, Botswana, Cyprus, Gambia, Malaysia, New Zealand, Samoa, Seychelles, Singapore, Solomon Islands, South Africa, Tonga, Trinidad and Tobago have very little or zero government ownership like the UK. As to foreign owned bank assets, Botswana, Gambia, New Zealand, Samoa, Solomon Islands and Tonga have practically out-sourced their banking industry whilst Bangladesh, Cyprus, Guyana, India, Malawi, Nigeria, Seychelles, Slovenia, South Africa, and Trinidad and Tobago have very low figures. Only 12% of developing countries make their regulators legally liable for their actions; 25% of countries have a deposit insurance scheme. Depositors in the remaining 75% of countries with no deposit insurance must carry out their own monitoring of these banks. Further studies on foreign bank presence in developing countries reveal that they represented 18% of the total number of banks in those countries. Some countries apply stringent capital requirement for foreign bank branches. But the UK, which did not divulge this figure to the World Bank, is neutral about the way foreign banks operate in London.

The UK authorities do not apply any capital requirements whatsoever for foreign bank branches. At present, if a major international bank like the Citibank London is involved in a particular transaction, the UK authorities expect that the deal will be supported by the entire capital of Citibank and not just by the capital of its London branch. If a poor country's branch wants to set up in London, the UK usually requires that they also set up a subsidiary before the UK grants the licence. But according to the Basle Concordant, host authorities are responsible for foreign bank establishments in their territory Basle Core Principle 23 stipulates that banking supervision must practice global consolidated supervision. over their internationally active banking organisations, monitoring and applying prudent norms to all business conducted world-wide.

A home country supervisory authority must safeguard the domestic financial system by preventing under-supervised foreign banking establishments in its jurisdiction. The UK must have figures for the percentage of its bank assets that are foreign owned although it chose not to reveal this figure, even though this information should be shared, although the UK did decide in February 2004 to sign a Memoranda of Understanding (MOU - a statement of co-operation between banking supervisors) with Korea,

This may be one reason why there are so many foreign banks in the UK, contrary to the situation in other EU member states who do comply with the Basle Concordant. This can be seen as a blatant breach by the UK of the Basle Accord which must not continue if the UK is to meet the requirements of the new Basle Capital Accord II

In 2005. The capital consequences for all foreign banks with branches in London are extreme.

One serious issue for developing countries with bank branches in the Western countries , less risky countries with lower capital requirements in the Basle II, is the problem of funding the capital required. The converse of this is that Bank supervisors in the developing countries must find the resources to regulate those branches of large international banks in their territory. How will countries such as Botswana, The Gambia, Samoa , Solomon Islands and Tonga afford expensive supervision of the foreign banks which make up their banking industry? Large international banks with branches in developing countries usually have very expensive centralised computerised systems and therefore supervisors in these developing countries will be forced to buy expensive computerised systems to enable them to carry out their supervisory and monitoring duties.

Another issue is that such countries as Botswana, The Gambia, Samoa, Solomon Islands and Tonga can easily follow Argentina's collapsing banking system largely owned by foreign banks, which can be extremely damaging to these countries.

In any case, the IMF empirical studies in 2000 convince that growth or volatility depend on the business soundness of a bank and not on its ownership.

Conclusion

It has been said that the UK financial regulatory system, recently consolidated, is second to none. The analysis has shown that some of its ‘virtues’ pose potential problems of conflict of interest, for example , in considering the independent Financial Services Authority (FSA) and its registration as a limited company , and financial independence from the government, it is not difficult to see the FSA increasing fines and nit-picking to create work in order to survive, thereby changing the whole chemistry of the authority from one of investigation and supervision to one that collects as much money as possible to maintain a comfortable existence for itself. It itself needs to become more transparent and accountable.

The serious problem of cost of technology and cost of training personnel remains for developing countries. The old adage that ‘more goes to those who have most’ spring to memory when it is considered that poor countries needing loans to build up their economies cannot easily obtain loans whilst those wealthy countries such as the USA and the UK, can borrow more and more on the strength that they will never be allowed to become bankrupt. It is said that the US has such a deficit that the US is now borrowing $2 Billion each day at present, yet poor countries cannot easily borrow.

Developing countries do not have the financial acumen to overcome impossible regulatory requirements through use of complex financial instruments. But they could overcome these obstacles by forming their own regional co-operatives, consolidate their stock exchanges, buying insurance from foreign countries, and so combat this ‘direct barrier to entry’. This is the opposite to the actions of the UK which centralised its stock exchange and made regional ones redundant.

Finally it must be said with surprise that the rapid rate of consolidation and regulation of EU states including the UK is disconcerting when one considers that the London Stock Exchange has been operating of a hundred years in a voluntary regulatory system. It is difficult to understand why it is said that the UK ‘could become the role model for a global financial regulator’ when it has no results to speak of and has been in operation for just under two years.

Money laundering, legitimizing the proceeds of crime including fraud, is a huge problem in the UK and it is common knowledge that the UK is a haven for money laundering, with its off-shore banks and embedded ‘old schoolboy network’ still strong.

But the main obstacle to the UK’s system being a model for the rest of the world is the fact that UK fraud this year totalled over £45 Billion pounds. We must lead by example and being the second most fraudulent country is not a good criterion for financial leadership.

Disclaimer: The law as stated in this article is the law at the date of writing. This article is for guidance and discussion and is not advice to any person in any particular case. Sally Ramage invites all comments regarding this article to be directed solely to her.

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APPENDIX 1

THE UK CONSOLIDATED FINANCIAL REGULATION MODEL

2000- Financial Services and Markets Act	UNITED KINGDOM (ONLY GOVT RULE- UK Govt will only borrow to invest. Public sector NET DEBT to be less than 40% of GDP.)	Financial Services Authority - a private limited company with regulatory powers conferred by statute
FSA can create and enforce detailed rules without Parliamentary approval.		supervision of banks , insurance and money market institutions
UK Treasury - supervision of FSA		Annual Reports filed like any limited company
1986 Financial Services Act -	Govt. regulation of banks, securities, insurance, building societies	Bank of England
1979-Exchange Controls abolished.	MORTGAGES & CONSUMER CREDIT	self-regulation

APPENDIX 2

COMMON LAW COUNTRIES - BANKING REGULATORY SYSTEMS

Country	Bank Regulator		Single?	Accountable to?
Bangladesh	Central Bank		yes	Government
Botswana	Central Bank			Government
Cyprus	Central Bank	yes		Bank Board & Government
Gambia, The	Central Bank	yes		Government
Ghana	Central Bank	yes		Bank Governor
Guyana	Central Bank	yes		Government
*India	Board of Financial Supervision (BFS)	yes		Reserve Bank of India
Jamaica	Central Bank	yes		Government
Kenya	Central Bank	yes		Government
Lesotho	Central Bank	yes		Bank Board
Malawi	Reserve Bank	yes		Government
Malaysia	Central Bank	yes		Government
*Maldives	Maldives Monetary Authority	yes		MMA Board
Malta	Central Bank	yes		Government
Mauritius	Central Bank	yes		Bank Board
Namibia	Central Bank	yes		Government
New Zealand	Reserve Bank	yes		Government
Nigeria	Central Bank	yes		Government
Samoa (Western)	Central Bank	yes		Bank Governor
Seychelles	Central Bank	yes		Bank Governor & Board
Singapore	Central Bank	yes		Bank Governor & Board
Slovenia	Central Bank	yes		Government
Solomon Islands	Central Bank	yes		Government
South Africa	Registrar of Banks	yes		Bank Governor & Government
Sri Lanka	Central Bank	yes		Bank Governor & Government
St Kitts	East Caribbean Central Bank	yes		Monetary Council
Tonga	Reserve Bank	yes		Government
Trinidad & Tobago	Central Bank	yes		Government
Vanuatu	Reserve Bank	yes		Government
Zambia	Central Bank	yes		Government
*UNITED KINGDOM	Financial Services Authority (FSA)	depends		Government
*UNITED STATES	Comptroller of Currency	depends		Government

Source: Extracted from World Bank Database of Country Replies to a questionnaire - year 2000

APPENDIX 3

STATISTICAL INFORMATION -BANKING IN COMMON LAW COUNTRIES

Country	Total Bank Assets per GDP(%)	% of Total Bank Assets Govt.Owned	% of Total Bank Assets Foreign Owned	Supervisors liability?	Deposit Insurance Scheme?	Enforcement Regulation Mandatory?
*Australia	?	0	17	no	no	no
Bangladesh	?	70	6	no	yes	no
Botswana	29	2	98	no	no	yes
*Canada	154	0	100	no	yes	no
Cyprus	76	3	11	no	yes	yes
Gambia	40	0	76	yes	no	no
Ghana	19	38	54	no	no	yes
Guyana	?	19	16	yes	no	yes
*India	48	80	0	no	yes	no
Jamaica	74	56	44	no	yes	yes
Kenya	56	?	?	no	yes	yes
Lesotho	?	51	49	yes	no	yes
Malawi	?	49	8	no	no	yes
Malaysia	166	0	18	no	no	yes
*Maldives	?	75	25	?	no	yes
Malta	291	0	49	yes	no	yes
Mauritius	96	0	26	yes	no	yes
Namibia	?	?	?	no	no	yes
NewZealand	154	0	99	no	no	no
Nigeria	28	13	0	no	yes	yes
Samoa	?	0	93	?	no	yes
Seychelles	?	0	0	no	no	yes
Singapore	?	0	50	no	no	?
Slovenia	66	40	5	no	no	yes
Solomon	?	10	90	?	no	no
S Africa	90	0	5	no	no	no
SriLanka	?	55	?	no	no	yes
StKitts	?	?	?	?	?	no
Tonga	52	0	100	no	no	yes
Trin,Tob	?	15	8	yes	yes	yes
Vanuatu	126	10	25	no	no	yes
Zambia	?	23	64	no	no	yes
*UK	311	0	?	no	yes	no
United States	66	0	5	no	yes	no

Source: Extracted from World Bank Database Built on Country Replies to Questionnaire -

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