Skip to 0 minutes and 1 secondMARTIN UPTON: In terms of the way in which regulation proceeds now, following the crisis, following the reformed regulation, is it really radically different? I mean the move from the so-called 'light touch/ principles-based' regulation which preceded the crisis to now a 'risk-based' approach to regulation, is this radically different or is it really just words?

Skip to 0 minutes and 23 secondsANDY HALDANE: It's radically different and let me explain why. There's at least two important dimensions to this. One is that we have completely re-calibrated the regulatory standards against which we hold financial firms. So our standards for the amount of capital a bank holds, the amount of equity against its loan book, have increased perhaps ten-fold relative to that pre crisis period. The bar has been set much, much, higher for how much of a capital buffer banks must hold. And similarly for example on - in terms of liquidity, the amount of liquid assets they have to hold in the event of needing to meet outflows from the bank - that standard too has been ramped up relative to its pre-crisis level.

Skip to 1 minute and 16 secondsSo the standards against which we are now evaluating banks have gone through a mini-revolution and that means those regulatory constraints are these days much more likely to bind on behaviour. That's one element. The other element has been our approach to enforcing um those standards. I mentioned the pre-crisis orthodoxy was perhaps to allow a somewhat laissez-faire approach of 'the banks know best'.

Skip to 1 minute and 52 secondsWell it turns out the banks didn't know best and therefore there is a very important role to play by the supervisors to hold banks to account, pro-actively, not probing after the event but before the event, a more intensive and perhaps some times intrusive approach to supervision to the questioning of the management of banks about how they are approaching risk management. So on both standards and on supervision I think the model these days is actually a fundamentally different one than that which existed ten years ago.

Regulation moves from ‘principles’ to ‘judgement’ and 'forward-looking'

In the video, Andy Haldane, chief economist at the Bank of England, talks about the changes to the way financial firms are regulated under the PRA and FCA.

Under the previous FSA regime, regulation was described as being ‘principles-based’. Just prior to the financial crisis this was described as follows:

‘principles-based regulation means, where possible, moving away from detailed prescriptive rules and supervisory actions about how firms should operate their business. We want to give firms the responsibility to decide how best to align their business objectives and processes with the regulatory outcomes we have specified’

(FSA, 2007, p. 4).

The inference is that financial firms were, to a degree, able to apply self-regulation to their business conduct.

Within this principles-based regulatory framework, the approach to the supervision was termed ‘risk-based’. This meant that the FSA focused its supervisory resources on monitoring and controlling the most material risks that arose from a firm’s business. The greater the perceived risks, the more intense the degree of supervision, and the greater the restrictions placed on the firm.

Principles-based regulation – sometimes referred to as ‘light-touch’ regulation – was deemed to have failed because the financial crisis revealed the inadequate management and business activities of several banks and other financial firms. Consequently it has been replaced by ‘judgement-based’ and ‘forward-looking’ regulation. What does this mean?

Under judgement-based regulation:

‘the nature and intensity of supervision will depend on the risks posed by each firm. Supervisory effort and resource will focus particularly on ‘big picture’ issues with potential systemic impact’

Source: HM Treasury, 2011, p. 11.

This approach is being adopted by the new regulators and it is ‘forward looking to take into account a wide range of possible risks to our objectives’ (Bank of England and FSA, 2012, p. 1).

Both the PRA and the FCA are reinforcing the ‘stress testing’ introduced by the FSA. Firms are now required to examine the impact of adverse developments affecting their business – whether specific to the firm or systemic. They then have to assess how they would respond in these circumstances and whether they have the capacity to continue with their business. This includes the requirement for firms to conduct what is known as ‘reverse stress testing’. This is where the firm considers the various circumstances that could, in theory at least, force them out of business and then work back (i.e. reverse) to the plans and safeguards they can put in place to minimise their future exposure to these risks. The circumstances that firms have to consider extend beyond adverse developments in their core businesses (e.g. a major recession reduces demand for their products) to a range of contingent, but possible, events like fraud, systems failures, adverse reputational developments and natural disasters.

Additionally, there is now a requirement for firms to establish planning processes to enable them to recover from major setbacks to their business. These requirements were set out in an FSA consultation paper, ‘Recovery and resolution plans 2011’ (FSA, 2011a). These recovery and resolution plans are aimed to help firms plan how they would try to recover from severely adverse conditions that could cause their failure. They set out in advance a firm’s ‘menu of options’ for dealing with a range of severe stress events.

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This video is from the free online course:

Finance Fundamentals: Financial Services after the Banking Crisis

The Open University