FSA revolution in regulating financial products

Updated March 2009

The Financial Services Authority (FSA) was criticised by the Treasury Select Committee for its failures and approach in regulating financial products in the past 12 months. Lord Turner admitted that the FSA’s light touch philosophy was a “mistake” and that dramatic regulatory changes were needed to build confidence in the market place. Lord Turner has publicly promised to reform the way that it polices the financial market. “This is not a small change. It amounts to a revolution,” Lord Turner said. 

Currently the FSA regulates companies and their markets, not the products they sell. Lord Turner said that the FSA would be proposing a host of new potential powers which will ‘revolutionise the financial industry’. This could lead to a move to prescribed financial product regulations equating to a fundamental shift in the FSA's policy of 'light touch' and principle based regulation.

The long awaited ‘Turner Review’, which will make recommendations for reforming financial services regulation, is due to be published on 18 March 2009. Lord Turner has indicated that the reforms are wide-sweeping and will impact on market practices and product construction. The reforms will cover the following:

• hedge funds to provide more data about their trading activities;
• tightening controls on credit rating agencies and auditors;
• reviewing corporate governance and remuneration policies such as City bonuses (addressing 'rewarding' short-term risk-taking);
• reviewing mortgage lending (ending 100% mortgages and possibly consideration of whether loans of up to 80% of a property’s value are too risky);
• reviewing deposit-taking and commercial banks’ operations of proprietary trading;
• reviewing capital adequacy rules to cover trading books with banks to hold “200% or 300%” more capital against risky trading books.

Additionally, a European taskforce, headed by Jacques de Larosiere, a former French central banker, proposes a new European system of financial supervisors to provide co-ordination for regulators overseeing large institutions. His recommendations includes the creation of a regional supervisor to monitor the biggest banks and lenders, but day-to-day supervision will be left with member states. The proposals will require a consensus among the European Union’s 27 countries and will also have to compete with rival ideas put forward by the European Central Bank, which wants to take on the supervision of the euro zone’s biggest lenders.

Impact on the industry

The FSA has acknowledged its failings in the past 18 months and it will start implementing a robust supervisory approach to regulation and management of market practices. Interestingly, there appears to be some differences of opinion between Lord Turner and Hector Sants (the FSA’s Chief Executive) as to the extent to which implementation of the FSA supervisory changes have progressed. We anticipate that the Turner Review will deliver reforms which will regulate financial products, especially those that are deemed risky, so there may be more prohibited products in the future. It is also anticipated that the FSA will demand that banks set aside considerably more capital to cover their trading books.

The FSA’s suggested recommendations may mean that firms will have to follow a prescribed list before product launch, perhaps with the FSA 'sign-off' of a generic product offering (possibly in a similar fashion to CAT standards). Crucially, this will mean tighter regulation and greater emphasis on micro management of firms and product offerings. Additionally, we anticipate that some sections of the FSA’s sourcebook will require amendments to reflect regulatory intervention of regulating financial products and there may even be new sourcebooks resulting from this regulatory shift.

As the FSA rejuvenates its supervisory mechanisms and revolutionises its regulatory framework we recommend that firms review their risk models and business process to adapt to economic pressures. Additionally firms will be expected to identify emerging business risks and carry out stress testing against both benign and economically more severe market scenarios before new products are launched. The Turner Review is potentially wide-sweeping and this year will see increased regulation for financial services providers.

This publication is intended for general guidance and represents our understanding of the relevant law and practice as at March 2009. Specific advice should be sought for specific cases; we cannot be held responsible for any action (or decision not to take action) made in reliance upon the content of this publication.