A New Era?

The newly formed Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) have their work cut out for them. Not only do they have to monitor one of the world’s largest and most active financial markets, they have to identify patterns and salient warning signs amongst a vast amount of data.   That much is clear from the Internal Audit Report into the LIBOR scandal published last month by the FSA. 

The Report concluded that the FSA, at all levels of management, was aware of severe dislocation in the LIBOR market in the period from summer 2007 to early 2009.  That conclusion was based on comments relating to ‘lowballing’ in just 26 of the staggering 97,000 documents reviewed in detail. 

On the basis of this analysis, the Report concluded that:

• The FSA was “too narrowly” focused in its handling of LIBOR-related activities, which was due to the regulator’s aim of dealing with the financial crisis, and the fact that contributing to and administering LIBOR were not  “regulated activities”;
• The likelihood that lowballing was occurring should have been considered given the information received; and
• The information received should have been better managed.

The Report contains a number of lessons for the successors to the FSA’s mantle.  It specifically addresses:

• the regulation of activities outside the regulatory perimeter and their implications;
• the roles, responsibilities and culture of the regulatory authorities; and
• how the regulatory authorities use and record information and intelligence, including circulating and escalating information and record keeping.

So by incorporating these lessons, are the PRA and FCA are more likely to spot LIBOR-like problems in the future, and more generally ‘do a good job’ in supervising the UK’s financial system? The Report was certainly exhaustive, but the reforms in the Report do not address key structural issues which hampered the FSA’s ability to do its job effectively, including in relation to LIBOR. These issues may provide more useful lessons for the PRA and FCA.

The Structural Problems of Regulators

Political Footballs?

Regulators are easy targets for politicians and the public more generally. Unlike the judiciary, financial regulators are not usually truly independent of government. Often their funding levels are at the whim of politicians and they have to justify their activities before parliamentary committees. This incomplete independence means that when markets fail, politicians can then blame regulators for failing to spot problems. When markets work, politicians can take the credit.

The FSA appears a good case in point. Then Chancellor of the Exchequer, Gordon Brown, was instrumental in creating the FSA through the Financial Services and Markets Act (2000). The guiding objectives of the FSA included market confidence, financial stability, consumer protection, and reducing financial crime.

Over the first decade of the 2000s, politicians could take the credit as London became an ever more important global financial centre. However, when the market collapsed, the politicians could blame the regulators for not taking action. Andrew Tyrie, the Conservative MP who heads the Treasury select committee, did exactly that in relation to the FSA’s handling of LIBOR, stating, “The FSA has admitted it had 26 warnings that this appalling practice was taking place. It also had other information that, taken cumulatively, ought to have set alarm bells ringing. It is concerning that no action was taken; that it wasn't tells us something may have been amiss at the FSA.”

In this context, something “amiss” can mean that the FSA was full of irresponsible and/or incompetent staff who failed to spot what was going on. On either reading, the hands of politicians who established the FSA and/or were responsible for setting economic and financial policy over the FSA’s existence, look clean when compared to the regulator. The FSA was also criticised for its performance in relation to other institutions such as Equitable Life, Northern Rock, and the Royal Bank of Scotland, and the politicians escaped blame.

Mandate

A key way in which regulators can be made scapegoats is through them having unclear mandates that are prone to manipulation. The FSA did not even have explicit responsibility for monitoring LIBOR submissions. However its general authority over financial services means that politicians could still tell the FSA that it “should have done something”.

Furthermore, the FSA’s mandate also included “the desirability of maintaining the competitive position of the UK.”[7] In the lead up to the global financial crisis UK politicians believed that this position could be maintained and increased through “light touch” regulation. Then Prime Minister Tony Blair claimed that his preference was to “approach regulation with caution”.[8] This view seemed to gain additional credence as capital flowed into London, and so provided a powerful incentive for the FSA to keep out of important areas and instruments of the market, including LIBOR. Again however, the FSA could be blamed when things went wrong.

Resources

The FSA’s challenges in relation to LIBOR also point to the problem of insufficient regulatory resources. Did the FSA really have the resources to monitor Libor, particularly at a time when the world’s financial system seemed to be in free fall? The FSA’s budget for 2010/2011 was £458 million (around US$700 million).[9] The World Bank calculated that the UK’s ‘domestic financial system depth’, consisting of a sum of domestic deposit bank assets, private debt securities, and stock market capitalisation, was US$8,400 billion.[10] At a very rough level, this means that each dollar for the FSA was meant to supervise around $US12,000 worth of the UK’s financial system. And that doesn’t account for the many trillions of dollars of derivatives trades the price of which was related directly or indirectly to LIBOR.  Was this a really feasible proposition?

Looking Ahead

Policy makers and the general community are right to be concerned about the FSA’s performance in relation to LIBOR. They are also right in trying to use lessons learnt from this performance into ensuring the successful operation of the PRA and FCA. However the ‘lessons learnt’ go beyond the limited and modest proposals outlined in the FSA Report.

The experience of the FSA suggests that the PRA and FCA will face structural challenges in their job, such as attracting political blame for crises. It remains to be seen whether these regulators have enough resources and a sufficiently clear mandate to perform their roles effectively. The PRA and FCA have big challenges ahead, and these challenges are much more fundamental than those unearthed by the LIBOR scandal.