Managing my financial journey
Managing my financial journey

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

In the following 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.

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Principles-based regulation

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 Consequently it has been replaced by ‘judgement-based’ and ‘forward-looking’ regulation.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?

Judgement-based regulation

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.

(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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