GlobalUK
7 October 2024
Now is a good time to assess the future of financial regulation and financial services in the UK. It is three years since the UK left the European Union. Since then, the government and regulators have been considering how to regulate UK financial markets and services. The huge Financial Services and Markets Bill (FSMB) is currently going through Parliament.
We are approaching the 10th anniversary of one of the biggest reorganisations of the UK’s financial regulation architecture. In April 2013, a system of dual financial regulation was created when the Financial Conduct Authority (FCA) [1] and Prudential Regulation Authority (PRA) [2] were established after the splitting up of the Financial Services Authority (FSA). Real progress has been made on financial regulation since the 2008 financial crisis and the litany of misselling scandals that left a legacy of mistrust. There is much to protect, and more to do to ensure financial markets work for consumers, the real economy, and the environment.
The government clearly sees the City and wider financial services [3] as one of the main engines of economic recovery both in its own right as a key contributor to GDP, and through financing economic recovery and growth. The government also wants the UK to become a global centre of green finance.
It is in the UK’s national interest that the financial services sector succeeds. Yet, it depends on how we define success and how it is achieved. Is it success on the City’s terms or on society’s terms? UK financial services may be huge but how economically and socially useful are much of its activities? What are the ramifications for citizens and the real economy if we return to a policy of greater financialisation?
The 2008 financial crisis was primarily caused by the behaviour of poorly regulated financial institutions. But, politicians must share the blame. Pre-2008, politicians encouraged the financialisation of the UK economy and adopted a light touch, permissive market-friendly approach to financial regulation. Financialisation undermined sustainable economic growth and contributed to regional inequality. Lessons there for a prospective Labour government that harks back to the New Labour period.
We are at a fork in the road when it comes to financial services and regulation. The decisions made by the government (and, if the polls are right, a forthcoming Labour government) about the future regulation of financial services will have consequences for UK citizens, the real economy, and the environment. The sheer size and influence of the UK financial services industry means decisions will have a knock on effect on global financial markets and efforts to move to a net zero global financial system. The UK needs to consider its role as a global citizen in financial markets.
Let’s start with the future of financial regulation. The signs are not good. The government’s strategy is based on financial deregulation to promote growth, both in financial services and the wider economy. Worryingly, the Labour Party, very likely to become the next government, seems to support this strategy.
The progress we have made on financial regulation since 2008 is under threat. Civil society organisations fear if the government’s reforms go through this could undermine the ability of financial regulators to fulfil their existing objectives. Consumer protection standards could be undermined, and the financial system weakened.
Sadly, the proposed regulatory reforms do not recognise the magnitude of challenges such as creating a net zero financial system, protecting citizens from the alliance of Big Finance and Big Tech/Big Data, or preventing financial exclusion and discrimination.
Climate change is an existential threat. Financing economic activities that damage the environment is arguably the greatest financial market failure. The UK plays a disproportionate role in exporting climate damaging finance. Yet, despite the government making big noises about making the UK a global centre of green finance, the FSMB does not give protecting the environment from harmful financial activities the same status in regulation as protecting consumers, maintaining financial stability, preventing insider dealing, or preventing money laundering. This is a remarkable failure of system governance by policymakers.
The government sets out in the FSMB a new secondary objective for regulators to facilitate the growth and competitiveness of the UK economy. This is risky. Financial regulators need to be watchdogs, not cheerleaders for the City of London. Growth must be sustainable, not at any cost.
If economic recovery is slow, it does not take much to imagine politicians putting pressure on financial regulators to weaken rules to get banks to take bigger risks when lending. If it looks like the UK finance sector is losing global business, it does not take much to imagine politicians pressurising regulators to weaken rules to allow the City to attract profitable international clients with fewer scruples about financial market integrity.
Financial regulators need the freedom to make independent decisions in the long term public interest, not be subject to short term political expediency. And we cannot forget our global responsibilities. We must not encourage regulatory arbitrage, a regulatory race to the bottom.
The ‘Edinburgh Reforms’ of UK financial services (also known as Big Bang 2.0) contained over 30 regulatory reforms which the government said would ‘unlock investment and turbocharge growth in towns and cities across the UK’. The Chancellor of the Exchequer set out plans to repeal, and replace, hundreds of pages of what the government described as ‘burdensome’ EU retained laws governing financial services. The stated intention is to establish, post Brexit, a smarter regulatory framework for the UK that is agile, less costly, and more responsive to emerging trends.
Let’s look at these claims that ‘reforms’ will unlock investment and turbocharge growth. The government is weakening a critical piece of insurance prudential regulation called Solvency II. Some of our insurers look stronger than they really are due to a financial conjuring trick [4] allowed for in Solvency II. This conjuring trick might create the illusion of financial strength but it allows insurers to create very real financial windfalls for their shareholders while transferring the risk of losses on high risk assets to policyholders. A case of ‘heads they win, tails we lose’.
If anything, insurance prudential regulation should be toughened given the state of the sector. Yet, the government is allowing insurers to make greater use of this financial conjuring trick. This will further undermine the security of peoples’ pensions. Moreover, in a separate move, it is weakening the charge cap rules which limit the amount City institutions can extract in fees for managing workers’ pensions.
Why would the government push through deregulation? Well, the government (and Labour) has bought the line pushed by the City lobbies that changing the rules would ‘free up resources’ to fund the green transition, levelling up, and economic recovery.
But, the government has not included anything in the deregulation that would ensure City private finance institutions funded net zero or adopted a long term view of investment. So, the government is weakening consumer protection and undermining the security of peoples’ pensions without the quid pro quo of applying rules that would ensure the City plays its part in funding net zero and levelling up.
The deregulation would allow City institutions to give shareholders further windfalls and extract higher fees from pension pots. The government even acknowledges that insurers could not be prevented from using these new found ‘freedoms’ to give shareholders further windfalls. It doesn’t take a cynic to think this was the real reason for the City’s lobbying for deregulation.
The Bank of England and PRA have made significant progress in improving systemic financial regulation and prudential regulation. The proposed competitiveness and growth objective will undermine the ability of regulators to focus on managing risks in the financial system. This is no time to weaken the defences that have protected the economy and households from systemic financial crises. Rather than weakening regulatory defences, the government should be ensuring financial regulators build up defences against risks in the shadow banking system. We need to do more to protect the financial system from the impact of climate change – and, just as important, to protect the environment from finance.
Even if the City did surprise us and invest more in the green transition, levelling up, or social infrastructure (such as social housing), this would be a very costly way to raise funds compared to direct government funding. Private finance institutions will demand high returns for providing investment. These returns have to be paid for. And it is ordinary households who will pay for those returns through higher charges and bills, greater value extracted from deprived areas of the country, and a further upward transfer of wealth. Remember, investment returns are a significant contributor to wealth inequality in the UK. There are more efficient, equitable ways to fund a just and fair green transition, levelling up, and affordable housing.
On the consumer protection front, there is much progress to protect and build on. The FSA was a unified regulator which covered consumer protection and conduct of business regulation, and prudential regulation and financial stability. This unified structure made it very difficult for a single regulator to manage so many operational objectives. The split made operational sense.
The FCA adopted a more robust approach to conduct of business regulation and consumer protection forcing up standards of behaviour of UK financial services firms. Of course, misselling scandals still happen. Some, such as the pensions transfer misselling scandal, were avoidable. But, we have not seen the same number of huge system wide misselling scandals such as mortgage endowment misselling, personal pensions misselling and, the biggest of all, the payment protection insurance (PPI) scandal.
Memories are short. It is easy to forget how rotten to the core much of our financial services industry was prior to the introduction of tough conduct of business regulation. The FCA should be given huge credit in the face of industry opposition for cleaning up retail financial services in the UK. Much of the criticism that continues to be levelled at the FCA is ill informed or plain unrealistic.
Some of the misselling scandals which have attracted much attention involved financial products and activities that were either partially or not at all within the FCA’s remit. In those cases, the fault lies mainly with politicians and government, not the FCA. The UK financial sector is certainly one of the biggest in the world and arguably the most complex. It is said that politics is the art of prioritisation. The same with regulation. Expecting regulators to devote the same amount of attention to preventing every potential misselling episode means the regulator would not be able to prioritise protecting the most vulnerable consumers.
We must avoid the FCA’s powers and duties being undermined by misguided attempts to light a bonfire of ‘red tape’, or its ability to fulfil its objectives compromised by this growth and competitiveness objective. The critical Consumer Credit Act is currently under review. It will be interesting to see who the government listens to – the lending industry or consumer advocates. Let’s hope the government listens to both.
We should also acknowledge how much UK consumers have gained from EU regulations across a range of financial products and services from investment services, knowing how much you are charged for having a bank account, protections when borrowing money, and having a legal right of access to a basic bank account. [5] Consumer advocates will have to be on guard to defend important EU-derived rights and protections. The government is reviewing these EU-derived regulations and seems intent on creating a spurious Brexit dividend by creating more finance-friendly regulation. Important protections could be lost, as much by accident as by design, if measures fall between the gaps as the government goes through the process of replacing EU regulation.
Financial services are becoming even more complex, the cost of living crisis increases consumer vulnerability, and the intersection of financial services and Big Tech (the digital shadowlands) is poorly regulated. The FCA’s job is getting even harder. The FCA currently has a very limited role in tackling financial exclusion and discrimination. There is almost no transparency on which financial firms treat vulnerable or excluded consumers badly due to the way commercial confidentiality is used to protect commercial interests. Civil society remains poorly represented in policy and decision-making in financial regulation. Industry lobbyists continue to dominate the process. [6]
If we want the FCA to become more responsive to emerging harms caused by financial innovation, then we need to speed up the process through which financial products and activities are brought within the FCA’s remit. By way of illustration, at the time of writing, the government has just announced draft powers for the FCA to regulate ‘buy now, pay later’ (BNPL) products, two years after a former FCA Chief Executive warned of the harm caused by BNPL and the urgent need to regulate all BNPL products. [7].
We obviously want to see financial innovation that benefits consumers and businesses. But, so much financial innovation over the years has not been economically or socially useful. There is a spurious proliferation of financial products and services. Relying on the magic of competition to improve the quality and value of financial products and services has just not been effective. A more robust, pre-emptive approach to financial regulation is needed to make financial services work. Contrary to the assertions of certain finance lobbies and market liberals, tough regulatory intervention supports not hinders economically and socially useful financial innovation.
As with financial stability and prudential regulation, it is about protecting the gains we have made on consumer protection and conduct of business regulation and building on those with more effective, robust regulation to make markets work.
The UK remains one of the leading global financial centres. Despite Brexit, the EU still matters to the UK financial sector and vice versa. Nevertheless, it must be acknowledged that the UK financial sector’s role and influence is at risk of being diminished due to Brexit. The government seems to believe that adopting an even more global outlook for finance can more than offset any loss of business due to Brexit.
There is a clear strategy for the UK to become more international in its outlook. It is not just the traditional areas of finance where the government believes the City can be competitive. Green finance has moved up the global agenda (even if action hasn’t matched the hype). The government says it wants to make the UK a leading global centre of green finance. The government also wants the UK to be a leading centre for fintech and associated technology and data services.
It is in the UK’s national interest that its financial sector succeeds. An efficient, effective financial sector is necessary to support the domestic economy, industrial policy, and environmental goals. A UK financial sector successful in international markets is important to the UK’s balance of payments.
But, it all depends on how the UK financial sector competes internationally. Decisions could have consequences for the rest of the global financial system and economy – for good and bad. The failure to properly regulate the UK financial system pre-2008 didn’t just hurt the UK economy and households. It created one of the major fault lines in the global financial system, triggering a global financial crisis and recession. So, we must ensure our financial system continues to be safe and stable in the UK’s own interests and in the interests of global financial markets.
The integrity and global reputation of the UK financial system was also damaged by light touch regulation which enabled money laundering and other dubious activities. Tougher regulation has been introduced to clean up the UK’s financial markets (although, of course, much more still needs to be done on this score, too). We cannot allow attracting a greater share of global business to take precedence over the quality and integrity of that business. Maintaining and improving standards of market integrity is surely a better way to compete and generate sustainable growth than reducing regulatory standards.
It would be a very positive development if the UK did become a global centre of green finance. But, again it all depends on how the UK does this. Does it attract business as a beacon of high standards and integrity on ESG finance? Or does it attract business by creating a green centre built on lower standards that facilitates green and impact washing?
The signs are not good. We are very much lagging behind the EU on climate-related financial regulation. The UK has missed its original plans for implementing its own green taxonomy. We are well behind the EU on developing a sustainable label to help investors to identify financial products which comply with green goals and in considering how to use prudential regulation to align financial institutions’ behaviours with climate goals.
Tackling climate change requires a coordinated global response. It requires consistently high standards. We have to hope that the government does not embark on green regulatory arbitrage to attract ESG finance. This will undermine efforts to create a global net zero financial system.
Civil society wants to see a successful financial sector. Yet, it cannot be success at any cost. It all depends on how we define success. Is it on the City’s terms or on society’s terms? The UK financial sector may be huge, but civil society organisations would challenge the economic and social utility of much of its activities. Returning to a policy of promoting greater financialisation will have ramifications for citizens and the real economy.
The City rightly stood accused of being more interested in financing speculative financial activities rather than supporting the real economy, of encouraging economic short termism, and of extracting huge value from peoples’ savings, insurance, and pensions in the form of high fees.
Financialisation doesn’t just create systemic risks that can destabilise the financial and wider economic system as in 2008. Financialisation is a major contributor to regional and intergenerational inequality. The short termism that goes hand-in-hand with financialisation undermines attempts to support the real economy as resources are pulled away from economically and socially useful activities to more speculative and value-extracting activities.
The decisions made by the government (and, if the polls are right, a forthcoming Labour government) about the future regulation of financial services will have major implications for UK citizens, the real economy, and the environment. The sheer size and influence of the UK financial services industry means decisions will have a knock on effect on global financial markets and efforts to move to a net zero global financial system. The UK needs to consider its role as a global citizen in financial markets.
The government’s regulatory reforms, if implemented, are likely to reverse the hard won gains we have made in improving financial regulation and making financial markets work. The UK’s approach to consumer protection and conduct of business, rightly well regarded around the world, is under threat. The security of peoples’ pensions will be undermined. All for what? There is nothing in the deregulatory reforms that will ensure that finance supports critical public policy goals such as the green transition or tackling inequality and promoting levelling up.
We are at a fork in the road when it comes to the future of financial services and, specifically, how the powerful financial services industry is regulated. We argue that the UK can compete internationally by being a beacon of high standards, not through regulatory arbitrage. We need to protect the UK financial system from the effects of climate change – and the environment from financial markets. The UK can take its global responsibilities seriously by setting the right example for global financial regulators on climate-related financial regulation. Domestically, the City can be made to work better for households and the real economy through progressive policies that align the sector’s interests with our interests. Financial markets should work for society, not just the few.
Mick McAteer
Co-Director, Financial Inclusion Centre, former FCA/ FSA board member February 2023
[1] The FCA is the lead financial conduct of business and consumer protection regulator. That means it regulates the behaviours of financial institutions and sets standards of market conduct. The FCA has a lot on its plate. It regulates the conduct of around 50,000 firms and prudentially supervises 48,000 firms.
[2] The Bank of England is responsible for maintaining the stability of the wider financial system. The PRA is situated within the Bank of England and is the lead prudential regulator. Prudential regulation relates to the soundness of individual financial institutions such as banks, building societies, credit unions, insurance companies and certain major asset managers. The PRA prudentially regulates around 1,500 firms.
[3] This includes associated professional services. Moreover, the role of fintech/ Big Tech/ Big Data is seen as playing a major part in this growth model. But, for shorthand we refer to the finance sector.
[4] The financial conjuring trick in question is called the Matching Adjustment. It is perhaps better called the ‘Magic Adjustment’ for the illusion of financial strength it creates. Details can be found here: Submission to HM Treasury Review of Solvency II consultation | The Financial Inclusion Centre
[5] The UK at the time tried to block this legal right, but was outvoted at the highest level by other Member States.
[6] For example, industry representatives dominated the Productive Finance Working Group which recommended the reforms to the charge cap on workers’ pensions, and will dominate the new working group being set up by the FCA to develop a voluntary code of conduct on ESG ratings.