The Parliamentary Ombudsman’s recent report on Equitable Life and the current focus on the financial health of the banking sector both raise the question of how liquidity and prudential regulation should be managed within financial institutions (see box “Prudential regulation in the UK”).
In her recent report on the Equitable Life saga, the Parliamentary Ombudsman (the Ombudsman) firmly laid the responsibility for the failings identified in the collapse of Equitable Life on a failure for over a decade by the Financial Services Authority (FSA), among others, to exercise properly its regulatory functions in respect of Equitable Life (Equitable Life: a decade of regulatory failure (HC 815), www.ombudsman.org.uk/improving_services/special_reports/pca/equitable_life/index.html).
In the Ombudsman’s view, it was not the system of regulation in place, rather the failure of those responsible for implementation to deliver regulation in a proactive and vigorous way, that was to blame for what she termed “the serial maladministration”. Specific examples are:
An over-reliance by the FSA on information provided and a failure to question or seek to resolve issues arising within the annual regulatory returns concerning the way in which Equitable Life’s solvency position had been calculated, even though the FSA was under a duty to do so.
A failure to resolve apparent issues of non-compliance and omitted information within the regulatory returns which led the reader of those returns to make an incorrect assumption that Equitable Life was more financially sound than it actually was.
As a result, the FSA did not exercise its powers to intervene and so prevent further loss to policyholders.
The Ombudsman described the FSA as ineffective, inappropriate and passive in this case. She recommended that the government apologise to policyholders for the “serial regulatory failure” and establish a compensation scheme that is independent, transparent and simple to administer.
This sends a clear message that, where institutions fail, not only are senior management to be held responsible for their own regulatory failings due to a lack of appropriate systems and controls, poor management and reporting, but that regulators are also expected to play an important part in the enforcement of those regulations through the proactive exercise of their powers and closer scrutiny of the financial institutions that they regulate, or they will also be held accountable.
The Ombudsman further noted that the failings, alongside cases such as Northern Rock, “illustrate the need for absolute clarity as to what can and cannot be expected from financial regulation and the development of shared understandings as to the limits to the protection that such regulation offers to investors both before and after problems arise, as they inevitably will.”
It is interesting to make comparisons with the latest developments in the banking sector. In February 2008, the Basel Committee on Banking Supervision (BCBS), a global forum for regular co-operation on banking supervisory matters, consulted on the paper “Liquidity Risk: Management and Supervisory Challenges” (www.bis.org/publ/bcbs136.pdf?noframes=1).
The BCBS analysed the causes that led to the banking system coming under severe stress in 2007, which necessitated central bank action to support both the functioning of money markets and, in a few cases, individual institutions. The difficulties outlined in the paper highlighted the fact that many banks failed to take account of a number of basic principles of risk management when liquidity was plentiful.
Many of the most exposed banks did not have a framework that satisfactorily accounted for the liquidity risks posed by individual products and business lines, and failed to take account of the wider impact of such products on the market as a whole. Banks did not consider the amount of liquidity they might need to satisfy contingent obligations, either contractual or non-contractual, as they viewed funding of these obligations to be highly unlikely and did not conduct stress tests that took into account the impact of market-wide strain caused by those products. The cause was held to be poor prudential management rather than a failure on the part of the regulators.
The BCBS recognised that, while surrounding circumstances differ, a pattern of events can be identified that is replicated in each instance where institutions suffered from poor prudential management: a so-called “cycle of risk” (see box “Risk failure”).
In June 2008, the BCBS, in a further consultation, set out principles aimed at tackling the problems in the financial markets arising from the credit crunch and associated borrowing restraints (Principles for Sound Liquidity Risk Management and Supervision, 17 June 2008, www.practicallaw.com/9-382-3180). These include:
Management and supervision of liquidity risk (principle 1).
Governance of liquidity risk management (principle 3).
Measure and management of liquidity risk (principle 6).
Public disclosure (principle 13).
The role of supervisors (principle 14).
The central theme of all these principles is that senior management should carry a greater burden in ensuring that liquidity risks are proactively managed and that at any point the tolerance to the impact of external developments should be sufficiently robust so that failures cannot occur.
Although the consultation has only just commenced, the UK has five representatives on the working group on liquidity: a larger contingent than from any other member jurisdiction (apart from the US). There will undoubtedly be an impact on UK regulation as a result, although in fact many of the principles mirror the FSA’s Principles for Businesses.
The FSA’s focus on liquidity issues is already clearly signposted with the issue of three joint Treasury, FSA and Bank of England consultations on a special insolvency regime for banks, financial stability and depositor protection and the FSA’s recent consultation: “Disclosure of liquidity support” (www.practicallaw.com/7-382-8640).
In light of these events, it is likely that the FSA will adopt a more proactive approach to prudential regulation across the whole of the financial services sector and will be more willing to intervene where senior management are not seen to be putting the appropriate systems and controls in place.
Pollyanna Deane is a partner at Berwin Leighton Paisner LLP.
The prudential regime in the Financial Services Authority’s Handbook of rules and guidance (comprising GENPRU and then the specific modules, INSPRU, BIPRU, MIPRU, UPRU, as well as certain parts as the former “interim” prudential regime) sets out prudential requirements for insurers, groups, mortgage firms, UCITS (undertakings for collective investment in transferable securities) firms and insurance intermediaries and, in relation to liquidity risk, for banks, building societies and own account dealers.
The aim is to protect the interests and reasonable expectations of policyholders, clients and consumers through greater emphasis on principles-based regulation. There is an increasing onus on senior management in firms to take responsibility for systems and controls and to ensure that appropriate risk management and controls are in place, together with reporting and escalation procedures, to ensure problems are identified and addressed at an early stage.
