Comprehensive Study Guide: The Regulation of Financial Services

Foundations of the UK Financial Services Regulatory System

• The current financial services regulatory environment is primarily based on three major pieces of legislation:

  • The Financial Services and Markets Act 2000 (FSMA).

  • The Financial Services Act 2012.

  • The Bank of England and Financial Services Act 2016.

• Other influential laws include:

  • The European Union (Withdrawal) Act 2018: This act "onshored" EU legislation into UK law before 31 December 2020.

• The Financial Services and Markets Act 2000 (FSMA):

  • Unified the regulation of all UK financial services sectors into a single regulatory system.

  • Scope: Includes bank/building society deposit taking, investment schemes, mortgages/loans, and all insurance contracts (General insurance, pure protection policies, and the Lloyd's market).

  • Regulated activities include: Dealing in, arranging, managing, or giving advice on listed activities, including using computer-based systems for investment instructions.

• Original single-structure framework established under FSMA:

  • One Regulator: The Financial Services Authority (FSA) (now disbanded).

  • One Ombudsman: The Financial Ombudsman Service (FOS), providing independent review of complaints that firms cannot resolve themselves.

  • One Compensation Scheme: The Financial Services Compensation Scheme (FSCS), responsible for paying customers if a regulated entity cannot meet its liabilities.

The Financial Services Act 2012 and the Restructuring of Regulation

• Effective in 2013, this act disbanded the FSA and split its responsibilities between three distinct bodies:

  • The Financial Policy Committee (FPC): A Bank of England committee that monitors emerging systemic risks and provides strategic direction for the regulatory regime.

  • The Prudential Regulation Authority (PRA): A part of the Bank of England responsible for the stability of systemically important financial institutions (banks, building societies, insurers). It focuses on ensuring firms can fail without collapsing the entire system.

  • The Financial Conduct Authority (FCA): An independent regulator focused on conduct of business for all firms and the prudential regulation of smaller, solo-regulated firms (e.g., mortgage and financial advisory firms).

• Crisis Management: The reforms clarified responsibilities between HM Treasury and the Bank of England. The Chancellor of the Exchequer has powers to direct the Bank if public funds are at risk or there is a serious threat to financial stability.

The Bank of England and Financial Services Act 2016

• Modified the Financial Services Act 2012 to strengthen the Bank of England's governance.

• "One Bank" Concept: Aims to allow the Bank to operate more effectively as a single entity.

• On 1 March 2017, the PRA ceased to be a subsidiary and became a part of the Bank of England.

• Prudential Regulation Committee (PRC): Established to supersede the PRA Board as the governing body. It operates alongside the FPC and the Monetary Policy Committee (MPC).

Principal UK Financial Authorities

• The UK financial landscape is managed by three primary authorities:

  • HM Treasury.

  • The Bank of England (including the PRA and FPC).

  • The Financial Conduct Authority (FCA).

HM Treasury

• Responsible for formulating and implementing the UK Government’s financial and economic policy.

• Primary Aim: Raising the rate of sustainable growth and achieving prosperity through economic and employment opportunities.

• It has representation on the FPC but lacks operational responsibility for the FCA or the Bank of England.

• Roles in financial contingencies:

  • Addressing economic disruption from instability.

  • Assessing costs/risks of support operations involving public capital (lenders of last resort).

  • Reviewing changes to laws or institutional structures.

  • Linking financial work with wider government frameworks for resilience.

The Bank of England (The Central Bank)

• Founded in 1694; nationalized in 1946; gained operational independence in 1997.

• Responsibilities: Settling of payments, functioning of UK markets, regulating banks/large firms, and provision of liquidity.

• Core Purpose 1: Monetary Stability. Includes stable prices and confidence in the currency. Defined by the Government inflation target of $2\% \, \text{CPI}$. Managed by the Monetary Policy Committee (MPC) through monthly interest rate decisions.

• Core Purpose 2: Financial Stability. Includes detecting and reducing threats to the financial system. Acting as a "lender of last resort" in exceptional circumstances.

Financial Policy Committee (FPC)

• Established 1 April 2013.

• Primary Objective: Identifying, monitoring, and reducing systemic risks to protect the resilience of the UK financial system.

• Secondary Objective: To support the Government’s economic policy.

• Membership: Representatives from HM Treasury, the Bank of England, the PRA, and the FCA.

• Output: Publishes a record of formal policy meetings and the bi-annual Financial Stability Report.

Prudential Regulation Authority (PRA)

• Regulates approximately $1,500$ firms, including banks, building societies, credit unions, insurers, and major investment firms.

• Statutory Objectives:

  • Primary: Promote the safety and soundness of regulated firms.

  • Insurance-specific: Contribute to protecting policyholders.

  • Secondary: Facilitate effective competition.

• Supervisory Approach: Outcomes-based and forward-looking, making judgments on future risks rather than just reacting to historical data.

• "Dual Regulation": The PRA works alongside the FCA in a structure often called "twin peaks."

Prudential Regulation Committee (PRC)

• The governing body of the PRA, established by the 2016 Act.

• Membership includes:

  • Governor of the Bank of England.

  • Deputy Governors for prudential regulation, financial stability, and markets and banking.

  • A member appointed by the Governor (approved by the Chancellor).

  • The CEO of the Financial Conduct Authority.

  • At least 6 external members appointed by the Chancellor of the Exchequer.

Financial Conduct Authority (FCA)

• Regulates conduct for $50,000$ firms and is the sole (prudential) regulator for $48,000$ of them.

• Responsibilities: FOS, FSCS, claims management companies (CMCs), and the UK Listing Regime.

• Strategic Objective: Ensure financial markets work well.

• Operational Objectives:

  • Protecting consumers.

  • Enhancing market integrity.

  • Promoting competition.

  • Secondary (since 2023): Facilitate international competitiveness and growth of the UK economy.

• Eight Regulatory Principles:

  1. Efficiency and economy.

  2. Proportionality.

  3. Sustainable growth.

  4. Consumer responsibility.

  5. Senior management responsibility.

  6. Recognizing differences in business models.

  7. Openness and disclosure.

  8. Transparency.

The Impact of International Regulation and Brexit

• Post-Brexit, the European Union (Withdrawal) Act 2018 onshored many EU-inspired regulations (e.g., MiFID II).

• Passporting Rights: Under EU single market directives, firms in one EEA state could trade in another without separate authorization. These rights were lost after Brexit, except for transactions with Gibraltar (extended until at least December 2025).

• Firms previously passporting into the UK could obtain temporary Part 4A permission to operate as Third Country Branches.

Key EU/International Directives and Regulations

• MiFID I and II: Regulates firms providing services linked to financial instruments (shares, bonds, derivatives).

  • MiFID II (effective 3 January 2018) added transparency, product governance, cost disclosure, and reporting of valuation losses greater than $10\%$.

  • "Article 3 MiFID exempt firms" are often IFA firms that only advise/arrange and don't hold client money.

• Insurance Distribution Directive (IDD): Succeeded the Insurance Mediation Directive (IMD).

  • Mandatory $15 \, \text{hours}$ of professional training per year for staff.

  • Introduction of Insurance Product Information Documents (IPIDs).

  • Professional Indemnity Insurance (PII) minimums: $€1,300,380$ for a single claim; higher of $€1,924,560$ or $10\%$ of annual income (aggregate limit up to $£30 \, \text{million}$).

• Alternative Investment Fund Managers Directive (AIFMD): Regulates managers of hedge funds, private equity, and real estate funds.

• Packaged Retail and Insurance-based Investment Products (PRIIPs): Requires a Key Information Document (KID). The UK is diverging from EU PRIIPs rules to simplify disclosures.

Capital Requirements and Basel Accords

• Basel I (1988): Strengthened stability via higher capital ratios.

• Basel II: Introduced a three-pillar framework:

  • Pillar 1: Minimum capital requirements for credit, market, and operational risk.

  • Pillar 2: Supervisory review and additional capital for other risks.

  • Pillar 3: Market discipline through public risk disclosures.

• CRD IV/Basel III: Focused on high-quality capital, liquidity/leverage ratios, and capital buffers for systemic firms.

Anti-Money Laundering (AML)

• 4MLD: Introduced customer due diligence for domestic Politically Exposed Persons (PEPs) and the registration of UK trusts with tax liabilities.

• 5MLD (implemented 2020):

  • Covers letting agents, art dealers, and cryptoasset providers.

  • Public beneficial ownership electronic lists.

  • Registration of all UK express trusts (not just those with tax liabilities).

• Joint Money Laundering Steering Group (JMLSG): Produces industry guidance for AML compliance.

• Financial Action Task Force (FATF): International organization setting global AML standards.

Other UK Regulators and Oversight

Competition and Markets Authority (CMA)

• Investigates mergers, cartels, and unfair trading practices.

• Strategic goals include effective enforcement, extending competition frontiers, and refocusing consumer protection.

The Pensions Regulator (TPR)

• Regulates work-based pension schemes to ensure they are adequately funded.

• Powers: Fining individuals up to $£5,000$ and companies up to $£50,000$, appointing/prohibiting trustees, and winding up schemes.

• ESG/Climate: Since 2021, larger schemes (>£1 \, \text{bn} assets) must report climate-related risks consistent with TCFD recommendations.

Information Commissioner’s Office (ICO)

• Enforces UK GDPR and the Data Protection Act 2018 (DPA 2018).

• Oversees Freedom of Information and Privacy and Electronic Communications Regulations.

Professional Oversight and Corporate Governance

Senior Management Responsibility

• SM&CR (Senior Managers and Certification Regime): Holds individuals accountable for business outcomes.

• Management Information (MI): Senior managers must use regular reports (KPIs, customer satisfaction, complaints) to ensure the fair treatment of customers and meet reporting requirements.

Compliance and External Support

• Firms remain responsible for compliance even if using external consultants.

• Accountants/Auditors: Regulated firms have special requirements for capital adequacy and client asset audits. Under SUP 3.1, firms undertaking MiFID II, UCITS, or IDD activities generally require a statutory auditor.

• Trustees: Must exercise a duty of care. ESG and sustainability factors are increasingly considered part of this duty; the Financial Markets Law Committee (2024) expects trustees to understand financial risks of climate change.

Questions & Discussion

• Question 4.1: Who are the UK financial authorities?

  • Answer: HM Treasury, the Bank of England's Financial Policy Committee and Prudential Regulation Authority, and the Financial Conduct Authority.

• Question 4.2: Which body produces guidance to help those in the financial services industry comply with anti-money laundering obligations?

  • Answer: The Joint Money Laundering Steering Group (JMLSG).

• Question 4.3: Which regulator is responsible for preventing the misuse of the assets of an occupational pension scheme?

  • Answer: The Pensions Regulator (TPR).

• Question 4.4: Why might the senior managers of a firm collect and monitor management information?

  • Answer: Management Information may be collected to meet regulatory reporting requirements, to help managers understand trends in sales, revenue, costs, and complaints, and to help improve business practices.