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Konoe, Sara (2012). “The Failure of an Integrated Regulatory Model?: The U.K. in a
Time of Crisis.” Economic Society of Kansai University Working Paper Series, F57.
Working Paper Series F57
The Failure of an Integrated Regulatory Model?:
The U.K. in a Time of Crisis
Sara Konoe
Faculty of Economics
Kansai University
8th July 2012
Economic Society of Kansai University
Osaka, 564-8680 JAPAN
2
The Failure of an Integrated Regulatory Model?:
The U.K. in a Time of Crisis
Abstract
The U.K.’s financial regulatory system, which was represented by an independent
supervisor—the Financial Services Authority (FSA)—had once been reviewed
positively. Transformative and speedy institutional changes, such as the establishment
of FSA in 1997 and its strengthened role by the Financial Services and Markets Act
(FSMA) in 2000, were made possible by the political leadership of Prime Minister Blair
and the Chancellor of the Exchequer Brown, as well as the U.K.’s majoritarian political
system. However, when the 2007-09 global financial crisis hit the U.K., its regulatory
framework lost its prestige. After a series of failures of financial institutions including
Northern Rock, the existing regulatory system was much criticized for its ineffective
supervisory practices and the malfunctioning tripartite system in crisis management
between the HM Treasury, the Bank of England (BOE) and the FSA, thus leading to a
symbolic decision: the break-up of the FSA. By analyzing institutional impact on the
development of the crisis and the subsequent reform, as well as political and economic
context where organizational changes occurred, this paper addresses the question about
why a particular regulatory model was chosen at a particular time, and draws
implications for a global regime responsible for financial oversight by pointing out
remaining future agendas.
Keywords: financial supervision, the United Kingdom, Bank of England, Financial
Services Authority, financial crisis, financial reform
JEL classification: F59; G01; G38; K20
3
1. Introduction
This paper analyzes which factors affected the sequence and direction of the
United Kingdom’s financial regulatory reforms in the 1990s and the early 2000s. By
analyzing the history of regulatory changes, the paper especially examines the role of
the 2007-09 financial crisis that influenced the reform characteristics and what these
changes could mean in a broader context of supervisory reform at regional and global
levels. Based on the case study of the U.K. financial reforms, this paper attempts to
draw implications for larger questions: how contextual (either economic or political)
and institutional (either regulatory or political) factors could impact the development of
crises and financial reform, and why particular regulatory models have been chosen at
given times in a country whose political system has particular characteristics.
This case study focuses on the reforms of supervisory organizational structure in
financial regulation. In particular, prudential regulation is the focus of this study, among
many aspects of financial supervision that could include conduct-of-business and
consumer protection issues. A question about what kinds of regulations are agreed upon
and enforced seems to be more relevant than a question of who regulates the markets.
However, due to a wide scope of interpretation inherent in law and regulations, the
organizational structure of supervision could still matter in the implementation of
regulatory goals. Although this study does not examine the contents of regulations in
detail, the ensuing discussions need to be reassessed in light of the substantive analysis
of regulations.
Barth, Caprio, and Levine (2006) examined the relationship between political
system and banking policies: democratic and open systems foster private market-based
monitoring and less restriction on the markets. Admittedly, there should be some
long-term influence of political institutions on supervisory power. However, contextual
factors need to be taken into account as an intermediate variable to explain a regulatory
model as well as its actual power and functions. Political and economic contexts (such
as a financial crisis) could matter in influencing the directions of supervisory
organizational reforms and the ideas about which structure is better than others. Even a
crisis with a limited scope, such as the run on Northern Rock, may have had a long-term
impact on discussions over which regulatory organizations are better than others, and on
actual functions and power given to a regulatory authority. The 2007-09 global financial
crisis made market failure problems more imminent, thus providing a rationale for the
enhanced consolidation of supervisory power in order to address market failures. The
2007-09 financial crisis most directly and significantly affected the financial sector in
advanced industrial democracies; a perception shift occurred primarily among financial
policy-makers in these countries.
According to MacNeil (2010), it has been difficult to precisely identify the causes
of the 2007-09 financial crisis due to the interplay of many factors at the national,
regional, and international levels. The recent undertaking of regulatory restructuring in
the U.K., at least, shows that a political judgment has been made to attribute relevant
causal factors to the existing regulatory framework.1 It has to be remembered that the
pre-crisis major regulatory reform in 1997 in the U.K. (i.e., the creation of an integrated
1. MacNeil, 485-87.
4
regulator, the FSA) intended to achieve economies of scale and scope in regulatory and
supervisory practices across different financial sectors in an increasingly integrating
financial market (Briault 1999). The decision to split up the functions of the FSA may
seem to be contradictory with what was attempted in 1997. Questions need to be asked
about how different contexts behind these reforms—whether pre-crisis or
mid-crisis—can explain how an institutional shift occurred in such a short interval and
what this could imply for actual supervisory practices.
In recent decades before the crisis, the U.K. system had attracted many
international businesses, partly because of the perception that the FSA’s practices were
less intrusive. Cassis (2010) commented:
It was widely acknowledged until the financial crisis of 2008 that, with the
Financial Services Authority, founded in 2000, London had a regulatory
environment that was superior to that of its main competitors, especially New
York, Frankfurt, and Paris. […] It was undoubtedly as much the consequence as
the cause of the City’s international pre-eminence—and the big banks are
unlikely to leave London with the end of “light tough” regulation.2
The economic benefit and political privilege enjoyed by the City of London and
its regulator, the FSA, could not be maintained as the crisis heavily saddled the U.K.
and uncovered the negative aspects of the past regulatory framework. Regulators seem
to have taken blame, at least symbolically, by the break-up of the FSA, while the
influence of the City of London may have been somewhat mitigated through a series of
financial collapse.
2. Driving Force for Regulatory Integration
2-1) Does Democracy Favor a Particular Banking Policy?
A linkage between political institutions, on the one hand, and banking policies
and regulatory and supervisory organizations, on the other hand, has not yet been
thoroughly examined, except for in a few pieces of work including Barth, Caprio, and
Levine (2006). Barth et al. (2006) examined the impact of political systems “along a
spectrum from those geared toward protecting and advancing the interests of small elites
to those based on more open, competitive, democratic institutions.”3 In general terms,
through an illustrative comparison between Mexico and the United States, Barth et al.
(2006) point out that a competitive and open political system helps a country to avoid
channeling funds and directing a banking system in favor of a small, dominant group.
Moreover, they conducted a large-N empirical analysis to systemically examine
the relationship between democracy and banking policies, and between democracy and
supervisory organizational structure. Their results showed 1) a statistically significant
positive relationship between democracy (i.e., an open, competitive, and democratic
political system) and banking policies that foster private market monitoring (e.g.,
information disclosures, etc.), 2) a statistically significant negative relationship between
democracy and regulatory restrictions on bank activities and government ownership of
banks,4 and 3) no significant relationship between democracy and the strength of
2. Cassis, 292. The FSA was proposed in 1997 and given a full power through the FSMA in 2000.
3. Barth, Caprio, and Levine, 286.
4. Bank regulatory policy variables are constructed based on World Bank Survey that reflects
updates for the year-end of 2002 (ibid., 76). Banking policies indexes are constructed based on the 2003
5
official supervisory power (i.e., the authority to demand information, or intervene in a
problem bank, etc.).5 In a democratic political system, the last point is explained by its
ambiguous attitude toward supervisory power, since:
democratic political systems may be either (1) wary of the potential corrupting
influence of bank supervisory power or (2) keen to overcome market failures
with strong official supervision. […] Democratic political systems might have a
public interest desire to ameliorate market failures, but worry that establishing a
powerful supervisory agency will facilitate private interest activities.6
Thus, “countries may choose to have powerful or weak supervisory agencies for
very different reasons.”7
2-2) Liberalizing Financial Markets and Regulatory Responses
While available research suggests that democracy is likely to reduce regulatory
restrictions, can political institutional indicators really explain the recent-decades
changes in regulatory policies? From the 1980s to the early 2000s, after the collapse of
the Bretton Woods system, financial markets were liberalized to a great extent with
increasing cross-border capital mobility, the removal of capital control, and
technological advancement. For example, cross-sector entry restrictions to financial
businesses and interest rate controls were deregulated in industrial economies where
they were formerly restricted, and various kinds of capital market products and
activities (e.g. mutual funds, derivatives, and securitized products) were permitted to
expand. It would be difficult to attribute the driving force of this trend to the possibility
of industrial economies having become more democratic,8 since from the 1980s to the
early 2000s, no significant democratization trends could be found in these economies,
except for a limited number of transitional economies in Central and Eastern Europe.
To examine the factors that drove the financial liberalization in these countries,
alternative explanations can be found in single-country or comparative case studies. For
example, Johnson and Kwak (2001) note that in the U.S., it was the role of Wall Street’s
increasing influence over Congress and bureaucratic officials through campaign
contributions and personal exchanges that led the country to liberalization.9 In the
analysis of deregulatory politics in the U.S. from the 1980s to the 1990s, Reinicke
(1995) shows how regulatory fragmentation among multiple regulators in that country
led to de facto deregulation and undermined the separation between commercial
banking and investments that had been imposed by the Glass-Steagall Act. Deeg and
Lütz (2000) describe the role of European integration and enhanced competition in
capital markets in helping the formation of liberalization initiatives under a
public-private alliance between Germany’s large private banks and the government, thus
leading to securities market consolidation and integration. These accounts point to the
role of a tie between business and politics, and that of regulatory fragmentation, global
competition, and market integration, in facilitating financial liberalization.
World Bank Survey, and political institution variables are constructed based on Policy IV data from 1998
to 2002 (ibid., 288-91).
5. Ibid., 297-306.
6. Ibid., 305. 7. Ibid., 305. 8. To empirically examine this question, a study on a sample of advanced industrial economies in
their time series data must be conducted.
9. Johnson and Kwak, 90-104.
6
Financial market integration progressed both across national borders and across
different financial sectors. Cross-border integration led to policy initiatives toward
international regulatory harmonization through the developments of the Basel Accords.
As discussed by Oatley and Nabors (1998), Singer (2004), and Drezner (2007),
politicians’ or regulators’ responsiveness to rising competition from foreign financial
sectors, and the concern over stability issues raised by financial crises in the 1980s,
helped countries to come together and decide on a common framework—the Basel
Accords—to ensure a level playing field.
Cross-sector integration brought about policy initiatives toward regulatory
integration by reducing differences in standards between sector-based regulators (e.g.,
banking, securities, and insurance regulators) or through the organizational
consolidation of their entities. Some countries have sector-based multiple financial
supervisors, whereas others have a single consolidated one. In recent decades, there has
been a shift from a multiple-regulator system to a single-regulator system. The
emergence of a financial conglomerate embracing different financial services made such
a sector-based multiple-regulator system ineffective to monitor an entire entity, thus
provided justification for regulatory integration across sectors by consolidating financial
regulators; the 1997 reform in the U.K. was one of them. The 1997 reform was
undertaken to achieve economies of scale and scope, as well as to avoid confusion over
who regulates what.10
Other research highlighted the positive effect of a
single-regulator system on the soundness of the banking system. Barth, Dopico, Nolle,
and Wilcox (2002) found a statistically significant positive effect of having a single
regulator on equity capital ratio (the ratio of equity capital to assets) and a negative
impact on liquidity risk (the ratio of loans to assets plus the ratio of deposits to assets),
at least for a country sample which excluded transitional economies.11
2-3) Choosing Financial Supervisory Models
Barth et al. (2006) show an undetermined relationship between democracy and
supervisory power. In addition, the actual power and functions of a supervisory system
could be affected by the specific regulatory model to be chosen (Barth et al., 2002).
Financial regulatory and supervisory operation includes diverse tasks that require
different skills and knowledge, and the ways in which responsibilities are allocated have
been a contentious issue. Under a consolidated regulatory model with cross-sector
integration, there are still multiple options to be chosen: the consolidated supervisory
authorities under 1) the central bank, 2) the finance ministry, 3) those that are
independent of both the finance ministry and central bank, or 4) the separation of
supervisory authority over financial stability and solvency matters and
conduct-of-business issues (i.e., the “twin-peaks” model).
The effectiveness of the first model was challenged when rapidly-developed
securities markets raised a series of investor protection claims before the 1997 reform in
the U.K (e.g., mis-selling of pensions; see discussion in Section 2-4). The second model
10. Darling, 19.
11. Barth, Dopico, Nolle, and Wilcox 170, 175, 176-81 and 185. Concerning the impact on liquidity
risk, low values of F statistics and of adjusted R-squared were noted. They consider that more illiquid
loans or more liquid deposits will increase liquidity risk (ibid., 170), but alternative reliance on wholesale
funding as opposed to deposits, may increase liquidity risk even more, given the example of Northern
Rock. Indicator must be improved in light of the 2007-09 financial crisis.
7
was criticized during the financial crisis in Japan, when financial supervisory practices
were not undertaken independently of other fiscal policy concerns, ultimately leading to
the delay of regulatory intervention and public fund injections. Before the 2007-2009
financial crisis, the third model found favor; some countries with multiple regulators or
supervisory authorities under the central bank moved toward this third model, as
suggested by Masciandaro (2004). For example, Norway (1986), Iceland (1988),
Austria (2002), Denmark (1988), Germany (2002), Sweden (1991), the U.K. (1997),
Estonia (1999), Latvia (1998), Malta (2002), Hungary (2000), Japan (1998), and South
Korea (1998) each introduced a single financial authority to supervise the entire
financial system.12 This was a part of an organizational shift from “function-based” to
“objective-driven supervision,” as defined by Lannoo (1998), and, as discussed above, it
arose from the integration of financial sectors through conglomeration and the
increasing difficulty of maintaining functional divisions within the business.
The fourth model, known as the “twin-peaks” paradigm, has been considered
effective for countries with mature securities markets, although the U.S. version of this
model did not attract much support because of its combination with multiple regulators
whose jurisdictions were divided along the lines of federal or state, or between sectors.
The model distinguishes financial stability and solvency issues from
conduct-of-business issues such as transparency and disclosure. The countries with
significant securities-market funding tend to develop independent and stringent
supervisory authorities over investor protection and conduct of business. The
twin-peaks model has been supported by Michael Taylor and the Wallis Commission in
Australia, among others.13 Netherland and Australia have maintained this model such
that a central bank plays a role as a financial supervisor with its authority being limited
to stability issues.
In most cases of a twin-peaks model, the central bank takes a role in financial
stability, whereas there is a separate agency overseeing investor protection issues.
Regardless of a central bank being an overarching supervisor (the first model) or being a
watchdog limited to stability matters (the fourth model), the involvement of a central
bank in supervision has been debated. Both advantages and disadvantages of locating
financial supervisory functions under the central bank have been made clear. A central
bank could be well-suited for supervising banks, since it has direct access to bank
information through monetary policy operations and it usually plays a role of lender of
last resort. In contrast, a central bank that combines supervisory functions may
encounter the temptation of relaxing monetary policies too much in order to mitigate
financial distress among financial firms. In addition, there may be spillover reputational
damage on a central bank as an independent monetary authority if it fails in effectively
supervising financial institutions.14 Moreover, Barth et al. (2002) found a statistically
positive effect of a central bank being a supervisor on the ratio of non-performing loans
12. Masciandaro, 152, 155-56. However, each country’s model greatly differs in its arrangement
and often comprises the elements of other models. For example, in Germany, the consolidated financial
regulator, the federal financial supervisory authority (BaFin: Bundesanstalt für
Finanzdienstleistungsaufsicht) is located under the umbrella of the Federal Ministry of Finance (BMF:
Bundesministerium der Finanzen), although its operation has been made independent from the influence
of the BMF. BaFin and Bundesbank cooperate to conduct financial supervision.
13. For the summary of discussion involving regulatory models, see Davies and Green, Global
Financial Regulation, 189-94, and Hall, 48-50.
14. Garicano and Lastra, 9.
8
(NPLs) to total assets. This might suggest that a separate single supervisor tightens
supervisory practices, although a low NPL ratio could merely reflect a lack of
transparency and the overvaluation of problematic assets.
When the 2007-09 financial crisis hit the U.K., a single-regulator model (the
third model) where supervisory power is held at the FSA outside of the Bank of England,
was questioned due to its perceived failures to supervise banks and undertake prompt
handling of troubled or problematic banks. As mentioned by Garicano and Lastra (2010),
the 2007-09 financial crisis “decisively shifts the argument” against a
single-financial-regulator model that is separate from a central bank. Garicano and
Lastra (2010) go on to say that “[w]e learnt again, in the Northern Rock debacle which
caught the Bank of England completely unprepared, that the Central banks absence
from supervision or closer involvement in the pursuit of financial stability has enormous
costs.”15 A political decision was made to choose a “twin-peaks” model (the fourth
model) in which the central bank plays a supervisory role over stability issues. In the
sections below, the paper addresses the following questions: How can this swift move
be made possible and how can it be interpreted? Did an integrated regulatory model
actually fail?
2-4) The Politics of Institutional Changes
Tsebelis (2002) explained that the U.K.’s majoritarian Westminster system can
favor dynamic, but unstable, policy changes due to a limited number of veto points,
through which powerful opponents could block government actions despite the support
of a political majority. That is, once the political majority is formed, it can bring about
transformative changes, although such policy changes could be easily negated and
replaced by the next majority after a change in administration. This system is contrasted
with political systems with many informal or formal veto points (typically seen in Japan
or the U.S.), as defined by Cox and McCubbins (2001), in which policy opponents can
find multiple channels to impede rapid policy changes. In the latter system, once
changes are made, their implementation tends to be fairly stable. According to Mahoney
and Thelen (2010), in a system of weak veto players, institutional changes can be
characterized as “displacement (outright changes of existing arrangements)” or
“conversion (substantive changes through interpretation),” rather than “layering (new
rules attached to existing ones)” or “drift (changes due to neglect of an institutions).”
The dynamic but fragile reform paths of the British financial system match this
theoretical expectation. Both pre-crisis and post-crisis financial regulatory reforms were
put through with a change of administration: from the Conservative Party to the Labor
Party and from the Labor Party to the Conservative-Liberal Democrat party coalition.
The first reform in 1997 responded to a series of supervisory failures, and subsequent
criticism against a self-regulatory structure based on the two-tier system of the
Securities and Investments Board (SIB) and Self-Regulation Organizations (SROs) and
against the oversight role of the BOE as a banking supervisor. The fraud or failure in the
banking sector, such as Johnson Matthey Bankers Ltd. in 1984, the Bank of Credit and
Commerce International (BCCI) in 1991, and Barings in 1995, uncovered the limited
capacity of the BOE, whereas the Maxwell affair and the mis-selling of pensions in the
early 1990s called the effectiveness of the self-regulatory system into question. The
15. Garicano and Lastra, 10.
9
BOE was considered to be poorly suited for monitoring complex multinational banking
groups, and the awareness of close cooperation between banking and securities
regulators was raised, thus leading to a decision to create an integrated financial
regulator, the FSA, in 1997. The FSA gained full force through the enactment of the
Financial Services and Markets Act (FSMA) in 2000.16
The second reform responded to the failures of the financial system revealed in
the midst of the 2007-09 global financial crisis, symbolically represented by the failure
of Northern Rock. While addressing bank failures, the tripartite system of crisis
management between the FSA, the BOE, and the Treasury was deeply criticized for its
ineffectiveness. After complaints were raised against the FSA’s supervisory practices in
the lead-up to the crisis, and with the aid of a change in administration, a new
framework was decided upon to split the FSA and transfer most of its responsibility
concerning financial stability to the BOE, either under its direct oversight or through its
subsidiary. Davies and Green (2010) note that, in a time of crisis, “issues related to bank
rescues and the provision of lender of last resort support once again assumed
prominence, and the links between supervisors and central banks again appeared
crucial.”17
This policy change came through as liquidity issues were perceived to be much
more important than formerly believed, both at national and international levels, during
the crisis.18 As Scott (2010b) explained, the crisis revealed the reality that the “run”
could happen, even with the presence of a deposit insurance system. With the
reoccurrence of significant financial crises that had been absent since the 19th century,
the central bank’s role has become much more pronounced again. Milne and Wood
(2008) emphasized the effective role of central bank as a lender of last resort to ensure
financial stability from the 19th century up to the recent crisis, and asked why this did
not work in Northern Rock’s case. They stated that it became politically difficult for
politicians to let depositors suffer from financial firms’ failures since most depositors
are no longer prosperous citizens like they were in the 19th century, and, despite this
change, a deposit insurance scheme had remained defective and insolvency schemes for
banks did not exist in the U.K. before the run on Northern Rock. In a research interview
led by the author, Prof. Geoffrey Wood also pointed out that the BOE’s lack of access to
information due to the demise of discount markets and the transfer of supervisory
authority to the FSA, led to the BOE’s diluted or ineffective role in ensuring and
16. In September 2005, I highlighted this reform process in my presentation at the American
Political Science Association (APSA). The following literature discusses the regulatory structure and
process related to the 1997 reform: Peter Sinclair, “The Financial Sector,” in Blair Effect: The Blair
Government 1997-2001, ed. Anthony Seldon (London: Little, Brown and Company, 2001); Eilís Ferran,
“Examining the UK’s experience in adopting the single financial regulator model,” Brooklyn Journal of
International Law [online journal]; available from
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=346120, Internet. Accessed on June 30, 2012;
International Monetary Fund, “United Kingdom: Selected Issues.” IMF Staff Country Report no.99/44
(1999) [database online]; available from http://www.imf.org/external/pubs/cat/longres.aspx?sk=2994.0,
Internet. Accessed on June 30, 2012.
17. Davies and Green, Banking on the Future, 70.
18. The improved understanding of liquidity is essential. Persaud (2010) points out the negative
side of mark-to-market accounting that forced financiers with long-term funding commitments to sell
assets in the credit crunch, thus worsening the crisis. He notes that “[t]he risk management, valuation and
accounting system that the institutions with overnight funding use should be different than the one that
the long-term investor should use (Persaud, 156).”
10
managing financial stability.19
Consolidating prudential responsibilities under a central bank may not be
enough, however, to address the problem of too many decision-makers, or too many
heads, in crisis management. As the following section shows, successful crisis
management also depends on the scope and timing of the Treasury’s ability to provide a
government guarantee; thus, a new framework would not be immune to a coordination
problem between multiple authorities.20 The 2007-09 financial crisis spurred
discussions over a governance scheme determining collaborative terms between the
Treasury and central bank in the financial stability matter, not only in the U.K., but
beyond.
3. Northern Rock’s Impact and Proposed Reforms
3-1) “The Run on the Rock”
The run on Northern Rock in September of 2007 struck a blow to the U.K. Such
a significant crisis had not occurred in the U.K. since the 19th century. The crisis
management system did not work properly this time, and the failure led to the overhaul
of its financial regulatory/supervisory architecture afterwards. Northern Rock’s
challenges began with its growing assets and short-term financing. It grew from £15.8
billion at the end of 1997 to £101.0 billion at the end of 2008.21 To finance growing
assets, Northern Rock increasingly relied on more money from the wholesale markets
(such as the interbank market) and the use of securitization by creating a vehicle called
Granite. The portion of retail funds (as opposed to wholesale funds) to the total
liabilities and equity declined from 62.7% at the end of 1997 to 22.4% at the end of
2006. In contrast, as of the end of 2006, the portion of wholesale funds to the total
liabilities was 24.0%, and that of securitization was additional 39.8%.22 Both
securitization and other wholesale funding matured in the short term and required
refinancing on a regular basis. In response to the warnings issued by the BOE and the
FSA, Northern Rock tried to change its strategy, but it did not prevent the subsequent
bank run.23 Rapidly rising assets and plummeting share prices that began in February
2007 signaled the presence of a problem.24
The House of Commons Treasury Committee’s report stated:
insofar as the FSA undertook greater “regulatory engagement” with Northern
Rock, this failed to tackle the fundamental weakness in its funding model and
did nothing to prevent the problems that came to the fore from August 2007
onwards. We regard this as a substantial failure of regulation.”25
In addition, the report highlights the role of an oft overlooked issue in the crisis,
which was the liquidity aspect: “[t]he problems affecting Northern Rock were those of
19. Prof. G. Wood, personal communications, March 14-15, 2012.
20. Scott, Reducing Systemic Risk, 772.
21. Milne and Wood, 3.
22. Ibid., 3-5.
23. House of Commons, 15. In response to the crisis, the House of Commons Treasury Committee
examined the cause of this extraordinary crisis and published its report, “The Run on the Rock,” in
January 2008. Concerning the pre-crisis warning, see also Milne and Wood, 9.
24. House of Commons, 23-24.
25. Ibid., 24.
11
liquidity and funding, rather than solvency,”26 but liquidity regulation had not yet
drawn significant attention at that time, and, even at an international level, agreement
with respect to liquidity regulations has not occurred.27
Eventually, the BOE’s liquidity support seemed necessary to keep Northern
Rock running. After possible takeovers of Northern Rock by other banks (such as
Lloyds Bank) and the covert operation of the liquidity support from the BOE to
Northern Rock turned out to be (or was judged to be) difficult, the tripartite authorities
of the Treasury, the BOE, and the FSA decided to announce the BOE’s liquidity support
to this troubled institution. Unexpectedly, this plan was leaked at night on September 13,
2007 through BBC before it was initiated. The deposit run on the bank began on the
next day, and continued until the Chancellor of the Exchequer announced a full deposit
guarantee on September 17, 2007.28
The report criticized the tripartite authorities for their failure to make a timely
decision by saying “[i]t is unacceptable, that the terms of the guarantee to depositors
had not been agreed in advance in order to allow a timely announcement in the event of
an adverse reaction to the Bank of England support facility.”29 The functions of
tripartite authorities have also drawn criticism in academics. For example, Hall noted
that “[t]he impression one gets from its operation in the run-up to and during the crisis
is that no one was in overall control with each party possessing an effective power of
veto.”30 In his memoir, then Chancellor Alistair Darling criticized the BOE for its
attitude toward crisis management by saying:
[m]y frustration was that I could not in practice order the Bank to do what I
wanted. Only the Bank of England can put the necessary funds into the banking
system […] The fact that we had given the Bank independence had a downside
as well as an upside.”31
Following extended lending from the BOE, Northern Rock was nationalized in
February 2008. Regulatory failure in the run-up to the crisis became a big issue. In
response, in March 2008, the FSA issued a report entitled, “The Supervision of
Northern Rock: A Lessons Learned Review,” and admitted its supervisory failure for
this incident as well as proposed the plans to overhaul the regulatory structure.32 In the
report, for example, a lack of resources and capacity used for this particular supervision
has been identified, while the emphasis on liquidity regulation was made for the
improvement of future regulation. Then Prime Minister Gordon Brown admitted his
mistake in creating the FSA by saying that, “we set up the FSA believing the problem
would come from the failure of an individual institution. That was the big mistake.”33
26. Ibid., 26.
27. Ibid., 28-29.
28. Ibid., 50-68.
29. Ibid., 71-72.
30. Hall, 52.
31. Darling, 23.
32. BBC News: http://news.bbc.co.uk/1/hi/business/7313896.stm; The FSA report on the case of
Northern Rock is available at: http://www.fsa.gov.uk/pubs/other/nr_report.pdf; Internet. Accessed on June
30, 2012.
33. BBC News: http://www.bbc.co.uk/news/business-13032013; Internet. Accessed on June 30,
2012.
12
3-2) Re-assessment of Existing Framework and a New Proposal
The collapse of Northern Rock was only the beginning of a larger banking crisis.
The failures of other banks and building societies followed, and bank bailout schemes
were implemented in October 2008 and January 2009. In response to the need for
strengthening regulation, the new Banking Act was enacted in February 2009, and a
new FSA chairman issued a “Turner Review” in March 2009 to provide a perspective
on the cause of financial crisis and better regulation (Financial Services Authority
2009).34
The FSA’s role
The role of the FSA and its regulatory practices was re-assessed after the crisis.
MacNeil (2010) noted the FSA’s wide discretion in “the regulatory techniques” and “the
intensity of regulation” outside a formal legal structure, and maintained that “the formal
legal structure of regulation can be of much less significance than the manner in which
regulation is practiced” such as so-called “light touch,” “risk-based,” and
“principles-based” regulation.35 In principle-based regulation, as mentioned by Davies
and Green (2008), the financial regulator does not have to identify “a particular rule
breach” but, rather, “the principles themselves can be used as the basis for enforcement
action.”36 Davies and Green (2008) continue to state, however, that this aspect needs to
be conditioned by the fact that rules written in the FSA Handbook have been extensive
and detailed.
Moreover, Ferran (2011) explained that the FSA concentrated too much on
consumer protection matters, rather than prudential regulation and systemic risk. For
example, he shows how few times the concept of “systemic” was mentioned in the
FSA’s annual reports in the early 2000s before the crisis.37 Darling (2011) also
mentioned that: “[t]he FSA […] had spent a great deal of time since its inception
concentrating on consumer issues, rather than examining the systemic risks […]”38 In
addition, Wood considered that this may be partly explained by the contradiction
between the task of consumer protection (or conduct of business) and that of prudential
regulation. For the purpose of consumer protection, keeping business open would be
preferable to closing down the business. In contrast, from a perspective of prudential
regulation, it may be necessary to close down the business before assets grow and
problems and resolution costs amass.39
In addition, as implied by Garicano and Lastra (2010), this may have something
to do with incentive distortion, depending on whether or not task and performance could
easily be measured.40 Conduct-of-business issues could be more objectively identifiable
in terms of whether certain actions could violate regulations, while risk assessment and
examination of banks could make it more difficult to reach objective judgment about
whether a bank should continue business, or whether it deserves a warning or a
34. Hall, 31-32.
35. MacNeil, 486-87.
36. Davies and Green, Global Financial Regulation, 207.
37. Ferran. 460.
38. Darling, 20.
39. Prof. G. Wood, personal communications, March 14-15, 2012.
40. Garicano and Lastra, 12-13.
13
regulator’s intervention to limit its business. This ambiguity comes from the nature of
prudential regulation where the valuation of assets could constantly change as economic
conditions and prospect change. If multiple tasks are combined within one entity,
employees’ efforts may be directed toward the former type of regulation.
The BOE’s role and other aspects
Even if the FSA had been eager to investigate systemic risk, things may not have
been so different for Northern Rock, whose asset size was ranked 8th among the U.K.
banks and building societies as of the end of 2006, and 9th for deposits.
41 As stated in
the Report to the G-20 Finance Ministers and Central Bank Governors in October 2009,
which was prepared by the International Monetary Fund (IMF), the Bank for
International Settlements (BIS), and Financial Stability Board, Northern Rock was
classified as one of six major British banking groups (MBBGs). However, it was not
thought to represent a systemic institution in the manner of its Big Four counterparts in
terms of its assets, liabilities, and stock market capitalization.42
Moreover, Milne and Wood (2008) emphasized that the BOE’s liquidity support
to Northern Rock was different from a central bank’s traditional role of lender of last
resort.43 They pointed out that “[t]here was a determined attempt to keep the institution
going, and to find a rescuer for it. This can certainly not be justified by the size or
reputation of Northern Rock.”44 If such non-traditional operation has become all the
more important due to the interconnected nature of financial transactions or the political
mandate of protecting small depositors not being solely comprised of the rich, the task
of prudential regulation gets closer to the field of crisis management operations, which
include liquidity provision and potential arrangements of rescue options. This means
that the recent financial market developments may have enhanced a central bank’s
required mandate for financial stability. This account sounds even more convincing in
the context of the increasing importance of “macro-prudential,” which is later discussed.
However, the BOE did not keep up with this expectation at that time. Darling
(2011) wrote:
(t)he Bank had concentrated on its monetary policy duties, primarily the
regulation of interest rate. Although it had had responsibility for financial
stability since becoming independent in 1997, it did not have a sufficiently deep
understanding of what was going on in the individual banks—or, indeed, of the
critical relationships within the banking system.”45
In addition, a problem existed in the terms of cooperation between the BOE and
the FSA, and between the three authorities, including the Treasury. According to
Darling (2011), “[t]he whole system depended on the chairman of the FSA, the
Governor of the Bank and the Chancellor seeing things in exactly the same way. The
problem was that, in September 2007, we simply did not see things in the same way.”46
They differed in opinion about whether the Bank “put money into the banking system,”
41. Milne and Wood, 4.
42. IMF staff et al., 16.
43. Milne and Wood, 27-32.
44. Ibid., 31.
45. Darling, 20.
46. Ibid., 21.
14
as did the European Central Bank (ECB) and U.S. Federal Reserve.47 Whereas the
FSA’s chairman and Chancellor called for earlier responses, the BOE was hesitant up to
the last minute of the crisis due to its concerns about moral hazard.48
Policy Shift
After blame was placed on the existing framework (especially the role of the
FSA), policy proposals were presented to improve the existing framework. In his
discussion of old and newly proposed frameworks, Hall (2009) noted:
[w]hat is clear […] is that the hoped-for change in supervisory culture—from
one based on trust among like-minded industry colleagues to a more intrusive,
questioning and adversarial approach—failed to materialize following the
handover of the regulatory reins to the FSA in 1997 […] the FSA proved
susceptible to special pleading from Government and industry alike for “light
tough” regulation—a clear case of political and industry capture of the regulator
[…]49
After the investigation by the House of Commons Treasury Committee and the
House of Lords Economic Affairs Committee, the government intended to implement
modifications to the existing system (Davies 2010). In July 2009, HM Treasury (2009)
proposed how a system should be reformed by strengthening financial stability
functions at the BOE and supervisory power at the FSA. However, the Conservative
Party accelerated its criticism against the existing authorities and further “settled on a
pre-election narrative which placed primary responsibility for the financial crisis in the
U.K. on Gordon Brown, and specifically linked that to the regulatory reform he
introduced in 1997.”50 Then Chancellor Darling under the Brown government admits
his responsibility in this matter:
“[t]he responsibility for the architecture was largely mine. When we were in
opposition in the early 1990s, Gordon had asked me to take responsibility for the
City. I realized quickly that getting the right supervision and regulatory regime
was essential and set about planning for the change in regulatory control which
we implemented once we were in power.”51
Reflecting the Conservative Party’s frustration and political strategy, subsequent
to the electoral winning of a coalition of Conservative-Liberal Democrats in May 2010,
a more thorough overhaul of the supervisory structure was announced. In his speech at
Mansion House in June 2010, Chancellor Osborne stated his doubt about the tripartite
system and the existing regulatory authorities’ lack of attention to macro-prudential
issues (e.g., the growth of assets and level of debts) by pointing out the BOE’s narrow
focus on consumer price inflation, the weak presence of a financial policy division of
the Treasury, and the FSA’s narrow focus on rule-based regulation. He further stated:
only independent central banks have the broad macroeconomic understanding,
the authority and the knowledge required to make the kind of macro-prudential
judgments that are required now and in the future. And, because central banks
are the lenders of last resort, the experience of the crisis has also shown that they
47. Ibid., 21.
48. Ibid., 21-24.
49. Hall, 50-51.
50. Davies, 96.
51. Darling, 19-20.
15
need to be familiar with every aspect of the institutions that they may have to
support. So they must also be responsible for day-to-day micro-prudential
regulation as well. […] In the agreement that forms the basis of this coalition
government, we stated our intention to give the Bank of England control of
macro-prudential regulation and oversight of microprudential regulation.”52
With the support of a new coalition government formed by the Conservative and
Liberal Democratic Parties, the BOE was given macro-prudential authority through the
creation of the Financial Policy Committee (FPC) and incorporated micro-prudential
function through the creation of its subsidiary, the Prudential Regulation Authority
(PRA). The consumer protection and conduct-of-business functions were separated
from these functions outside of the BOE through the creation of the Consumer
Protection and Market Authority (CPMA), along with the Economic Crime Agency
(ECA), an agency in charge of white-collar crime.
4. Perspectives on the New Framework
4-1) Post-Crisis Regulatory Integration
In the U.K., a new supervisory structure was created in 2010-12. Micro- and
macro-prudential functions, on the one hand, are now combined under the BOE into
different organizational entities: the PRA and FPC. Monetary and prudential policies are
combined under the BOE into different entities: Monetary Policy Committee (MPC)
and FPC. On the other hand, prudential regulation is separated from the
conduct-of-business authority, the former being assigned to the PRA and the latter to the
CPMA, so that it follows the “twin-peaks” model. Garicano and Lastra (2010) consider
that this model of splitting between micro- and macro-prudential supervision and
assigning the latter to the central bank provides an important linkage between the role of
lender of last resort and that of watchdog of the soundness of a financial market as a
whole, while avoiding potential reputational damage on a central bank in case of
supervisory failure at a micro-prudential level.53
The post-crisis U.K. reform may seem to be a backlash against the pre-crisis
global trend toward an integrated financial regulator, a trend described in Section 2.
Would this really be the case? In the U.S., sector-based and local-jurisdiction-based
regulatory fragmentation happened to be combined with a twin-peaks model, but a
twin-peaks model does not necessarily imply regulatory fragmentation in prudential
regulation. At least, the U.K. did not return to the pre-1997 regime, in which
sector-based and self-regulatory practices operated in combination with the overarching
banking supervision by the BOE. In addition, the fact that a new framework was
adopted in the moment of crisis and in the midst of regulatory tightening could make
differences in how regulatory organizations would actually function.
Opinions are divided about how a new framework should be interpreted in terms
of regulatory fragmentation or integration. Some criticize regulatory fragmentation
brought about by the split of the FSA into the PRA and CPMA. For example, Rawlings
52. “Speech at the Lord Mayor’s Dinner for Bankers & Merchants of the City of London by the
Chancellor of the Exchequer, the Rt Hon George Osborne MP, at Mansion House.” 16 June 2010, sent.
100-104. Available from http://www.hm-treasury.gov.uk/press_12_10.htm; Internet. Accessed March 6,
2012.
53. Garicano and Lastra, 10.
16
(2010) maintains that “firms will be subject to at least two regulators and […] to
different sets of rules […]” and warns of the possibility of “a risk of competition
between the agencies.” He takes a rather critical stance on these issues and notes that
“even if the FSA made mistakes, this does not mean the idea of a unified system was
wrong.”54 In contrast, if one pays more attention to the aspect of combining micro- and
macro-prudential authorities under the BOE, which has an independent authority in
monetary policy, this reform can be seen as a move toward regulatory integration. To
make a comparison with the fragmented regulatory system of the U.S., Scott (2010a)
stresses “the United Kingdom has moved toward even greater consolidation by making
the FSA, in effect, a subsidiary of the Bank of England.”55
4-2) The Role of the Central Bank in Prudential Regulation
By pointing out the problems of regulatory capture, or “groupthink,” in
micro-prudential regulation, John Gieve, the former Deputy Governor of the BOE,
stressed the potential role of the BOE (Bank) in macro-prudential regulation. In his
remarks on June 2009 before an official decision on this new framework, Gieve argued
that:
banks and regulators are in constant discussion and negotiation and tend to
develop shared views and shared misjudgments, as they did on structured credit
and wholesale funding. We need a second opinion and challenge from a body
that is not involved in day-to-day supervision but can take a view of the system
as a whole […] If, as I favour, we introduce a power to vary capital and liquidity
requirements with the economic cycle, the Bank should have the lead
responsibility for making those judgments.56
Briault (2009) emphasized “the collective intellectual failure” of which financial
industries and financial regulators were a part in the lead-up to the crisis.57 If such a
failure in perception is embedded in the existing regulatory structure, modifying
incentives of regulators through regulatory reshuffling may make a sense, as long as the
new framework is better at overcoming knowledge limitation by giving a regulator
some distance from an industry.
The increasing role or involvement of a central bank in macro-prudential
regulation is also supported by views expressed by Davies and Green (2010). They
maintain that:
(c)arrying out the day-to-day tasks of prudential regulation of individual
institutions is neither necessary nor sufficient to create the understanding of
financial stability […] But the central bank does need first-hand knowledge of
systemically important institutions, focusing on their liquidity, funding, and
capital adequacy.58
From this perspective, some distance between the PRA and the FPC can also be
justified, except for some systemically important financial institutions (SIFIs), while
others emphasize the benefit of combining micro- and macro-prudential regulation to a
54. Rawlings, 527.
55. Scott, A General Evaluation of the Dodd-Frank US Financial Reform Legislation, 479.
56. John Gieve. “Regulating banks calls for attack on inertia.” Financial Times, June 28, 2009.
57. Briault, Fixing Regulation, 12.
58. Davies and Green, Banking on the Future, 87.
17
fuller extent.59
In addition, the concern over potential conflict-of-interest issues between
financial supervision and monetary policy could be in part balanced out by a positive
synergy brought about by the combing two functions. In FSA Occasional Papers,
Briault (1999) stated that “[t]here is no firm empirical evidence of the monetary
authorities [’s…] loosening monetary conditions simply in order to support banks or
other financial institutions.”60 In recognizing the positive synergies that are created
when bank regulation and monetary policy are combined into one institution, Briault
(2001) stated that “the real issue here is […] whether the synergies in doing so are
greater or less than the alternative synergies arising from the creation of a single
financial services regulator.”61
Beneficial synergy between monetary policy and financial stability was also
acknowledged by Davies and Green (2010). They wrote that:
[t]he analysis of financial market developments … has not often influenced
debates in the MPC […] the need is to integrate the core functions of the central
bank, so that the two forms of stability can be seen as interconnected.62
This leads to their conclusion that “stresses in the financial system, ‘excess’
growth of credit, and the inflation of asset price bubbles need to be seen as political
justification for changes in interest rates.”63 Similarly, Allen and Carletti (2010)
emphasize the need for a check-and-balance mechanism of a central bank whose
policies tend to disregard any possible financial stability measures other than
narrowly-defined economic indicators when it makes monetary policy.64 They
considered low interest rates set by the U.S. Federal Reserve in 2003-04 to be a primary
contributor to the bubble in pre-crisis years. Low interest rate policy continued despite
the rapidly rising housing prices.65
The argument for maintaining a close linkage between monetary policy and
financial stability operations, including prudential regulation, can be made through the
understanding the causal relationship between economic bubbles and financial crises, a
topic frequently discussed after the recent crisis. According to Persuad (2010),
“[c]rashes follow booms, and the credit cycle is often an appendage of the economic
cycles. Consequently, any focus on systemic failure has to put the credit and economic
cycles at the heart of financial regulation.”66 Persuad continues by arguing that, in order
to reduce the housing bubble, regulatory intervention to lower the loan-to-value ratio of
mortgage lending would be more effective and less damaging to the economy than
tightening monetary policy.67 Potential interventional tools, ranging from monetary
policy to prudential regulations, need to be discussed and decided upon in terms of
which would be more effective and offer an advantage based on a cost-benefit analysis.
59. Buckingham, 33.
60. Briault, The Rationale for a Single Regulator, 28.
61. Briault, Revisiting the Rationale for a Single Regulator, 27.
62. Davies and Green, Banking on the Future, 88.
63. Ibid., 89.
64. Allen and Carletti, 17-18.
65. Ibid., 5-6.
66. Persaud, 153.
67. Ibid., 154-55.
18
4-3) Some Parallels to the EU Framework
As stated above, one of the concerns that used to be discussed with regards to
the central bank’s enhanced role in financial supervision was the conflict of interest
between monetary policy and prudential regulation. The central bank that holds
financial supervisory authority may want to avoid the failure of financial institutions
and be willing to provide a larger amount of liquidity to failing banks than the optimal
level justified from a monetary policy point of view. For member states within the
European Economic and Monetary Union (EMU), the creation of the European Central
Bank (ECB) helped them to overcome such concerns, and provided them with more
options in its supervisory models. Monetary policy mandates have been transferred
from national central banks (NCBs) to the ECB, thus making conflict of interest issues
less relevant when national central banks take a role as a supervisor.68 Examples
include a Dutch central bank, De Nederlandsche Bank, which became “an integrated
prudential regulator”69 with its supervisory functions over banking and insurance
sectors. In contrast, since the BOE has kept its monetary policy authority as a
non-member state of the EMU, the concern over conflict of interest issues would not be
resolved at the national level.
At the European level in the EMU, concern over the conflict of interest could
persist, as was the case for the U.K. The central bank model adopted at the EU level
resembles a new U.K. framework (except for the remaining sector-based feature at the
EU level), in terms of combining the monetary and macro-prudential authorities. In the
EU, the ECB enhanced its role in macro-prudential regulation by hosting the secretariat
of the European Systemic Risk Board (ESRB) in collaboration with financial
supervisors at European levels, including the European Banking Authority (EBA), the
European Securities and Market Authority (ESMA), and the European Insurance and
Occupational Pensions Authority (EIOPA), which are in charge of micro-prudential
regulation. The Treasury report issued in July 2009 before the decision of breaking up
the FSA expressed its support for the creation of ESRB along with its proposal of
strengthening the functions of prudential regulation in the FSA and BOE.70
As the crisis enhanced the public’s awareness of macro-prudential matters and
its linkage to crisis management processes, a new trend—a consolidated supervisor
under a central bank—gained support, at least in the U.K. At the same time, the crisis
highlighted how relevant technical discussions about prudential regulations and
financial stability operations can be to the public, and how important it could be to
make a financial supervisor more accountable. It became clear that the ultimate burden
would eventually be placed on taxpayers.
If a central bank gains more power over financial supervision, their institutional
status in relation to politics and to fiscal authority needs to be re-examined. Discussions
over how fiscal and financial authority should be linked, and to what degree they keep
some distance from each other, are underdeveloped. Japan’s model, in which the
ministry of finance served as the regulatory, led to disastrous crisis management in the
1990s. Tripartite arrangements between the FSA, BOE, and the Treasury did not work
effectively in addressing the crisis in the U.K. There are still relevant questions to be
68. Davies and Green, Banking on the Future, 206-09.
69. Ibid., 207.
70. HM Treasury, 96-97.
19
asked about an institutional design over financial stability issues. For example, how
independent should a central bank be in its financial stability operation?
5. Implications in a Global Context
This paper presented the political contexts and institutional structure which
affected the 2007 crisis management and the 1997 and 2010-12 financial supervisory
reform process in the U.K., and analyzed the basic elements of the latter reform.
Regulatory restructuring toward “re-regulation” in normal times, or in the absence of a
serious crisis with a systemic scope, may not be so effective when compared to actions
taken during times of crisis, since a new scheme may not accompany the “political
will”71 to enforce a newly built structure in a stringent way. This is evidenced by the
failure of the newly established FSA in the U.K., in which a new structure seemingly
could not make much difference in terms of the stringency of regulating markets in the
field of prudential regulation.
In the particular context of the post global financial crisis in 2007-09, Helleiner
and Pagliari (2011) argue that the international economic order has become increasingly
diffuse and diverse due to the increasing influence of emerging economies and the loss
of credibility of existing authorities in international financial regulation. In an
increasingly vulnerable financial market, and with enhanced attention to the timely
undertaking of crisis management and its linkage to prudential judgment, a trend toward
the consolidation of regulatory bodies in increasing coordination with a central bank
may attract the interests of other states, while the conglomeration does not seem to
cease to exist and, thus, continues to justify a consolidated regulator model rather than a
sector-based one. Enhanced attention to the macro-prudential could lead to further
integration, as seen in the U.K. reform, where micro- and macro-prudential maintain a
linkage with some distance.
Regulatory integration in a diffused world can be explained by distinguishing
regulatory fragmentation between sovereign entities from that within them. According
to Davies and Green (2008), “statutory-based” regulations that are enforced by each
sovereign entity and recognized in an international society could create tension with
those that are self-regulatory or sub-national. They argue that:
[w]here regulators operate in their jurisdictions on the basis of regulatory
standards imposed or maintained elsewhere, statutory regulation is evidently
preferable and may be required. It is difficult for a regulator in country A to
agree to place legal reliance on a regime of self-regulation in country B.
Thus, they postulate that the “trend towards statute-based regulation” is likely to
continue.72 The post-crisis diffusion of power could result in more regulatory
consolidation at the levels of entities that are given sovereignty over policies, in whole
or in part, which could reduce the scope of different practices at sub-national levels.
Thus, in a world of increasing power diffusion, the enhancement of a
national-level supervisory power may be still appreciated, in order to respond to
democratic states’ increasing concerns over market failures and their interventionist
stance. Apart from institutional options discussed in this paper such as the role of a
central bank in financial supervision and the relationship between micro- and
71. I thank Prof. Pepper Culpepper for his insightful suggestion.
72. Davies and Green, Global Financial Regulation, 213.
20
macro-prudential authorities, articulating ways to resolve accountability issues of
financial supervision and to build useful linkages between fiscal policy and financial
stability mandates without introducing overwhelming, ad hoc, and interest-group-driven
political influences, remains to be seen.
Author Note
I would like to thank the interviewees and scholars who provided me with relevant
information and advice. My appreciation goes to the interviewees at the FSA, Treasury, and the
BOE during the summer of 2006. I revisited this issue in 2011-12 after the financial crisis.
Special thanks are due to Prof. Geoffrey Wood, Mr. Clive Briault, Dr. Kevin James, and Prof.
Hal Scott for their insightful comments.
This paper is an updated version of a paper presented at the 19th International Conference
of Europeanists organized by the Council for European Studies and held on March 22-24, 2012,
in Boston, Massachusetts, U.S.A.
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