Committee Reports on Study Tour to United Kingdom (Inflation Targeting; Single Financial Regulator)

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Finance Standing Committee

24 February 2003
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FINANCE PORTFOLIO AND SELECT COMMITTEES: JOINT MEETING
25 February 2003
COMMITTEE REPORTS ON STUDY TOUR TO UNITED KINGDOM (INFLATION TARGETING; SINGLE FINANCIAL REGULATOR)

Chairperson: Ms B Hogan (ANC)

Documents Distributed:
Committee Report on Finance Study Tour to United Kingdom (Inflation Targeting) - see Appendix 1
Committee Report on Finance Study Tour to United Kingdom (Single Financial Regulator) - Appendix 2
Annual Committee Report [not available electronically until adopted]
Latest Committee Programme

SUMMARY
The Committee UK Study Tour Reports on Inflation Targeting and the Single Financial Regulator were adopted with amendments. The Committee 2002 Annual Report was postponed for adoption.

MINUTES
Inflation Targeting Committee Report
The Committee amended the Recommendations section to specify that non-Reserve Bank members sitting on the Monetary Policy Committee (MPC), did not include Treasury Department Officials. The Chairperson explained that under South African law the Reserve Bank is an independent institution and its independence should be protected.

Another technical amendment was made changing the wording under the heading General Comments by the Deutsche Bank, from 'it might be a once of thing' to 'it might be a singular occurrence'.

The report was adopted.

Single Financial Regulator Committee Report
The Committee adopted this document with one technical amendment.

Committee 2002 Annual Report
In reply to Ms R Taljaard (DP) asking why entry and exit dates of committee members to and from this Committee were not clearly indicated, the Finance Committee Clerk, Mr J Michaels, said members often get confirmation of their change in status before the Committee Clerk. This creates some confusion on entry and exit dates to and from committees. He noted that the Annual Report reflects only those changes that had occurred since 2002.

The Chairperson requested that all members refer such queries to the clerk who would remedy the situation.

In reply to Ms Taljaard asking what procedure was in place to ensure that the Committee's Annual Report would be studied and followed up, the Chair said that the Chairpersons' Committee would be the committee to contact in this regard.

The Committee did not adopt the Annual Report.

Meeting adjourned.

Appendix 1:
REPORT:

PORTFOLIO COMMITTEE ON FINANCE AND SELECT COMMITTEE ON FINANCE STUDY TOUR TO THE UK

INFLATION TARGETING

Comments by: Deutsche Bank - Ciaran Barr (Chief UK Economist);

Mike Biggs, George Buck

Wednesday 2 October 2002, 10:30am

1. History

Up until the introduction of inflation targeting, there was haphazard monetary policy in the UK. The impetus towards an inflation targeting regime was induced as a response to the crisis which occurred after sterling left the ERM in September 1992. Up until May 1997, government had still controlled interest rate decisions. The new Labour Government formalized the monetary policy regime in 1997. In May of that year the new Labour Government granted "operational independence" to the Bank of England to determine interest rates and introduced inflation targeting as the formal policy.

 

2. Key features of Inflation Targeting in the UK

    1. The primary aim of inflation targeting is to maintain price stability, with Government defining the target and the Bank having operational independence to achieve that target.
    2. Currently, and since the start, the RPIX inflation target (which is exactly the same as the CPIX) is fixed at 2.5%, at all times, with a 1% band of deviation on either side of that. In South Africa the target is based on a range and is specified for a period of time.
    3. If inflation deviates by more than 1% from the target (that is, 1.4 or below or 3.6 or higher), for reasons beyond the control of the Central Bank, the Bank is obliged to account for its failure to attain the inflation target. This is done through the mechanism of an "open letter" by means of which the Governor informs HM Treasury on the following matters:
    • Why inflation has moved away from target by more than 1%
    • What policy is being taken to deal with it
    • The period within which it is expected to return to target
    • How this approach meets the Government's monetary policy objectives
    1. The Monetary Policy Committee (MPC):

The MPC, which is housed in the Bank of England, deliberates and makes decisions on all matters pertaining to inflation targeting.

It consists of 11 members, of which 5 are members of staff of the Bank and 4 are external members not employed by the Bank and appointed by the Chancellor of the Exchequer. The Governor appoints Bank members.

There is a HM Treasury representative present at all MPC meetings, who represents the views of Treasury, however this representative does not have any voting powers. The HM Treasury representative provides input on the fiscal policy of Government and reports to Treasury.

The MPC meets once a month and the minutes of the MPC are published, within two weeks of their meeting. The minutes do not attribute comments to specific individuals, but the voting of specific members is noted. Explicit voting allows different views and can aid the credibility of the process.

One of the factors which the MPC has to take into account is whether inflation is being driven by demand or supply side factors.

The Chancellor can override a decision by the MPC in "exceptional circumstances". However, this cannot be done without first going through Parliament. The Chancellor has never used this power.

3. Environment in which inflation targeting was introduced

Inflation targeting was introduced into a benign inflationary environment. Inflationary pressures were falling. From 1992, the informal inflation target was between 1 and 4 % and in 1994 and 1995 it was at 2.5% or less. At the time, the market did not believe that the authorities would meet these targets.

There was excess capacity in the market. Output volatility was decreasing together with inflation. There had been a previous history of boom-bust economic growth, which had stabilized during the 1990's.

Major structural reforms of the British economy occurred which facilitated the introduction of an inflation targeting regime. Some of these included the decentralization of wage negotiations and large-scale privatization in the UK in the 1980's.

4. The UK Experience - Current status

The MPC has been relatively successful in containing inflation. In fact, it has consistently undershot its target. A consequence has been that the inflation target has "locked in" low inflation, with an overall diminution in volatility of inflation and output. The market (and public) expects low inflation to be maintained

 

5. Unforeseen consequences

  1. The continuing strength of the pound has directly contributed to the inflation undershoot in that the MPC made its decisions based on the notion that sterling would decline. However it did not decline. The consequence was that the inflation target was continuously undershot. This is the opposite of South Africa where it is continuously overshot. The MPC now follows a more pragmatic approach and is less inclined to follow a pre-emptive strategy on the same scale.
  2. Low inflation has lead to low interest rates which has in turn lead to a surge in consumer spending and has discouraged saving. This has had serious consequences, including a dramatic rise in consumer debt. It has also very importantly led to a massive increase in house prices, which could potentially have serious consequences for the economy.

The impact of MPC policy has been to encourage the surge in consumer spending which has helped to offset the deteriorating economic climate internationally.

6. General comments by Deutsche Bank

The Bank of England tends to ignore food prices in inflationary trends, even though food prices are included in the index. They are not a major factor in deliberations, although they are not completely excluded. Food is a much smaller proportion of the overall basket, only 11% as opposed to 26% in SA.

The Bank has to acknowledge the limits of inflation targeting in emerging markets, where exchange rates are likely to be more volatile. Therefore emerging markets often have a far more difficult task because they are subject to far greater pressures, therefore they should not be hesitant to invoke the escape clause. This should not be interpreted as reneging on the policy. The Bank must at all times account for a deviation from the target but the market needs to know that in adverse conditions the bank will stick to its target.

Inflation targeting has its limitations and the best way to deal with these is to be transparent. When the target is missed, it should be explained that the target has been missed, why it was missed and how the situation will be dealt with. It is important to recognize and to explain that the factors that may have caused the target to be missed may not occur again; it might be a singular occurrence.

 

Comments by: Bank of England - Sir Edward George - Governor;

Charles Bean - Executive Director and Chief Economist;

Andy Haldene - Head of International Finance Division;

Alastair Clark - Executive Director, Financial Stability

Wednesday 2 October 2002, 2:30pm - 5:15pm

    1. Inflation targeting has been the most successful monetary policy so far. It has been more successful than targeting the money supply or the exchange rate.
    2. The Bank does not see any trade off in the long term between growth and inflation because price stability is a necessary condition for sustainable growth.
    3. It is most important to differentiate between supply side shocks (where their effect on inflation often depends on why they have changed) and demand side shocks. The Bank of England follows the policy of demand management because it is operating on the demand side and can't control the supply side.
    4. The "open letter" can and probably should be used when there is a supply side shock (e.g. an oil price increase), but then the Bank should prevent the shock from leading to a secondary round of inflation.
    5. There has been remarkable stability in the economy. It has involved a continual quest to right the imbalance between the domestic economy and externally exposed factors.
    6. On the topic of the MPC, the Bank commented as follows:
    1. It is very useful having non Bank of England members on the Committee. It is a way of keeping the Bank in touch with other perspectives. They are all expert economists, and are not representatives of industry or trade unions. They each bring fresh thinking and they each have a specialty in a particular area.
    2. In order to have good non-Bank members, the country needs a sufficient pool of experts, which is not always readily available.
    3. There is a good argument for having these members serve for a longer term than three years (as in the UK).
    1. On the question of whether a Central Bank should stick to their target, no matter what, the Bank commented that policy makers do themselves a disservice by saying they will stick to a set of policies that are not credible. It is better to admit as quickly as possible and make the necessary changes. This should be done with a lot of explanation. If there is a logical argument for it, it will be more credible.
    2. The Bank commented that it would be inappropriate for the Chancellor to criticize the Governor in public. This would damage the credibility of the whole system.

 

Comments by: HM Treasury - Robin Fellgett - Director of the Financial Sector

Joined by Robert Woods - Head of Fiscal & Macroeconomic Policy

Andrew Wren - Financial Stability Markets

Friday 4 October 2002, 10am

  1. There is a HM Treasury representative on the MPC. This representative has no voting powers, but provides input on fiscal policy issues and provides feedback to Treasury.
  2. If the Minister or the Chancellor disagreed with a decision of the Governor, there is no law to prevent the Chancellor or Minister from making it public, but it is hard to imagine that this would ever happen. It would affect the credibility of the whole system.

The Bank of England's relationship with Parliament

Comments by: Treasury Select Committee in the House of Commons

Monday 7 October 2002, 2pm

  1. The primary relationship of the Bank of England to Parliament is with the Treasury Select Committee.
  2. The Bank of England produces quarterly inflation reports and appears before this Committee three times a year on these reports.
  3. Prior to these meetings, the Committee consults with its specialist advisors on the contents of the latest inflation report, so that they are fully prepared when the MPC appears before them.
  4. The Committee has 7 specialist advisors, from the city, specialists and academics. They are however not full time employees of the Committee.
  5. Various members of the MPC appear before the committee on a rotation basis. The reason they don't appear before the Committee four times a year, is that in the third quarter, (over August) it is recess and everyone is on holiday at that time.
  6. The Select Committee holds hearings on the appointment of new members, even though they don't have any statutory authority to do this.

 

Comments by: Economic Affairs Committee in the House of Lords and Michael Wickens, their specialist advisor. Monday 7 October 2002, 12 noon

  1. The Chancellor of the Exchequer appears before the Committee, with his chief advisors, twice a year.
  2. The Governor of the Bank of England also appears before the Committee twice a year.
  3. There is no relationship between the two Committees of the two houses of Parliament.
  4. With regard to how robust the debate between the Committee and the Governor is they commented that the debate is very robust. The Committee is not at all hesitant to raise any issue, however, will not get into technical discussions with the Governor. Technical questions are dealt with when the Deputy Governor appears before them.
  5. The Chancellor is under no obligation to appear before the Committee and he could refuse to come. However, this would both reflect badly on the Chancellor and would diminish the status of the Committee.

Recommendations:

1. The membership of non Reserve Bank representatives, excluding Treasury officials, on the MPC should be considered.

2. The invocation of the escape clause should not be seen as an abdication by the Reserve Bank of its commitment to maintain its target, but should be viewed as an instrument for the Reserve Bank to communicate in a transparent way, valid reasons why it has not met its target and how it intends to get back to the target.

The Report on the Overseas Visit by the Portfolio Committee on Finance, having been put to the Committee, was adopted by the Committee on the 25th of February 2003.

Appendix 2:
FINANCE PORTFOLIO AND SELECT COMMITTEE REPORT ON SINGLE FINANCIAL REGULATOR: adopted 25/02/2003

Bank of England - Sir Edward George - Governor;

Charles Bean - Executive Director and Chief Economist;

Andy Haldene - Head of International Finance Division;

Alastair Clark - Executive Director, Financial Stability

Wednesday 2 October 2002, 2:30pm - 5:15pm

Ernst and Young UK Financial Services Regulatory Practice

Andrew Winckler - Chair

Joined by George Elwes and Claire Davies

Thursday 3 October 2002, 8:30am

Financial Services Authority - Sir Howard Davies - Chair;

Christopher Boyce - Head of Public Affairs and Accountability

Thursday 3 October 2002, 11am - 1:30pm

HM Treasury - Robin Fellgett - Director of the Financial Sector

Joined by Robert Woods - Head of Fiscal & Macroeconomic Policy

Andrew Wren - Financial Stability Markets

Friday 4 October 2002, 10am

McKinsey & Company - Tim Roberts - partner

Toby Rougire - Partner

Paul O'Riordan - Partner

Friday 4 October 2002, 1pm - 3:30pm

  1. Introduction to changing trends in Financial Regulation

There have been a number of forces that have driven change in the regulation of the financial services industry globally, especially changes within the structure of the industry itself, as well as instances of serious corporate failures. These are all relevant to South Africa.

 

Changes in industry include:

      1. In the past, institutions within a particular sector of the industry used to provide services restricted to that particular sector. For example, banking services were provided by the banking sector and insurance services were provided by the insurance sector. However services and products are now being offered across sectors. Banks are providing insurance schemes and insurance companies are providing banking services.
      2. There have also been a number of mergers which means that big conglomerates now offer products and services across different sectors.
      3. Moreover, new products are being developed that can often have features of a number of sectors in the industry. Regulators were usually assigned to a sector or a number of sectors jointly.
      4. Other changes necessitating an overhaul in financial regulation include providers crossing geographic boundaries, the emergence of new distribution channels (internet), and consumers' demand for more 'wholesale-like' products.

Therefore, functional differences of the different regulators are becoming less distinct. With the breakdown of sectoral boundaries in the financial services industry, regulators now find that their boundaries are no longer clearly defined; hence the move towards transforming the regulatory structure in the financial services industry.

 

Instances of corporate failure include: the collapse of individual banks and investor protection failures which have lead to the need to restore confidence in the integrity of the banking system as a whole. Other instances include investor protection failures - e.g. pensions mis-selling in the U.K; periodic market instability and the impact of this on industry players; and a political/public desire to reform existing system.

As a result of these trends and events, there has been an international trend to consolidate regulatory bodies. Typically financial regulation consists of two aspects: (a) Prudential regulation which seeks to ensure the health of financial institutions and (b) Market conduct regulation which seeks to protect the consumer from unscrupulous practices. Different models for reforming financial regulation have been adopted in different countries. For example:

(a) Scandinavia:

The Scandinavians were the first to reform their regulatory system. They have a banking division, an insurance division and an investment/securities division. They simply put a single roof over all three of these. This was not a true integration of regulatory functions.

(b) Australia:

Under this model, the prudential and conduct-of-business regulations are dealt with by two bodies instead of one. They implemented the Twin Peaks model, which meant that prudential and conduct-of-business (market-conduct) regulation were consolidated into two bodies, namely the Australian Prudential Regulatory Authority (APRA) and the Australian Securities and Investments Commission (ASIC).

The Australians conducted a full review of regulatory structure (Wallis Enquiry) before making any legislative changes. Their Central Bank maintains responsibility for monetary policy and overall financial system stability.

(c) United Kingdom: (This will be discussed in more detail below under the heading "Structure of the Financial Services Authority (FSA)")

In the UK and Germany all regulators were consolidated into a single body organized along functional lines, namely: (1) authorization/licensing; (2) setting standards for firms (3) supervision; (4) enforcement. There is a completely separate ombudsman for receiving complaints.

The regulator is responsible for both prudential and market-conduct regulation as well as for both policy development and execution.

A report on reform of the financial regulatory system was commissioned by the Chancellor before these changes were made.

There was a 9-way (later 10-way) merger of existing financial regulators to create a new single integrated financial regulator, the FSA.

 

2 History of the establishment of the Financial Services Authority in the United Kingdom

The scandal that occurred in the UK associated with the collapse of Barings Bank gave impetus to the programme of overhauling the regulatory regime in the UK. It is interesting to note that the problem in Barings Bank occurred in the securities trading section, namely that part of the business that was not supervised by the Bank of England. This highlighted a serious regulatory gap and there was recognition of the need to improve financial oversight.

When the Labour Government came to power in 1997 it instituted steps for the transformation of the regulatory framework. The transformation was based on a Report received by the Chancellor.

Prudential supervision of the banking system was removed from the Bank of England and the function was transferred to the FSA. Likewise, the functions of other regulators in the financial services industry were also transferred to the FSA, which became responsible for both market conduct and prudential supervision. The Bank of England was granted independence to set interest rates in May 1997.

A memorandum of understanding between HM Treasury, The Bank of England and the FSA was drawn up in October 1997. It sets out the role of each institution and explains how they will work towards a common objective of financial stability. The division of responsibility is based on four guiding principles, namely: (a) clear accountability, (b) transparency, (c) no duplication and (d) regular exchange of information.

The Bank retains responsibility for overall stability of the financial system as a whole. To this end it publishes a regular Financial Stability Report. The report strives to make the Bank's activities as transparent as possible. Both the FSA and HM Treasury provide input into the report.

The FSA is responsible for prudential and market-conduct regulation of financial institutions. HM Treasury is responsible for the overall institutional structure of regulation and the legislation that governs it. It has no operational responsibility for the activities of the FSA and the Bank, but will need to be alerted should serious problems arise.

A Standing Committee of representatives of the three institutions meets on a monthly basis to discuss individual cases of significance and other developments relative to financial stability.

This committee brings together all the different perspectives. The FSA brings their expertise as supervisor, the Bank of England brings their expertise of oversight of the markets and the Treasury brings their expertise of the economy as a whole

There are also bilateral agreements (arising out of the tripartite agreement), between the Bank of England and the FSA to provide for the sharing of information and the cross secondment of people. The FSA has more information on specific firms, which the bank does not have; however, the Bank has broader market information.

Legislation providing for the establishment of the FSA was processed through lengthy discussion in Parliament.

On 1 December 2001 the FSA assumed its powers and responsibilities under the Financial Services and Markets Act 2000. The Authority is now the single statutory regulator responsible for the regulation of deposit taking, insurance and investment business.

 

3 Structure and functioning of the FSA

The FSA is a public body, set up by legislation (The Financial Services and Market Act 2000). It is a private company, limited by guarantee.

It has very wide-ranging regulatory powers. It is governed by a board of directors appointed by Treasury consisting of 15 members, 4 of which are executive directors and 11 of which are non-executive members.

It is entirely funded by levies from the financial services industry and receives no money from Government. It is operationally independent of Government and currently regulates approximately 11 000 firms.

3.1 The FSA's statutory objectives are:

  • Maintaining confidence in the financial system (Note, it is not the maintenance of financial stability)
  • Promoting public understanding of the financial system
  • Securing the appropriate degree of protection for consumers
  • Reducing the risks of financial crime

3.2 The legislation also sets out guidelines with regard to the principles of good regulation:

  • Using its resources in the most economic and efficient way (the non-executive committee of the Board has to oversee this and report to the Chancellor of the Exchequer)
  • Recognizing the responsibilities of regulated firms' own management (There was initially a fear that the FSA would interfere in the running of firms)
  • Being proportionate in imposing burdens or restrictions on the industry (Regulation must be proportionate to the risk)
  • Facilitating innovation
  • Taking into account the international character of financial services and the UK's competitive position; and
  • Facilitating, and not having an unnecessarily adverse effect on, competition.

3.3 Accountability of the FSA:

The Financial Services and Markets Act of 2000 clearly sets out all the objectives, as well as the general duties of the FSA. It states that the FSA must produce an annual report and must specifically report on their achievement of their objectives. The annual report must also include a report by the non-executive directors of the Board with regard to the economy and efficiency of the FSA.

The Treasury Select Committee exercises oversight over the FSA, and they have the power to summon witnesses, call for evidence and write reports. The FSA currently appears before the committee at least twice a year. One meeting is to look at the annual report (looking back) and one to look at their future plans (looking forward). The Chairman of the FSA attends these meetings and the committee publishes the evidence in a report.

The FSA makes it their business to be in touch with members of Parliament and hold regular briefings with them. It goes to the party conferences. They receive about 40 MP letters a week dealing with constituency business. In their view, their relationship with Parliament is constructive and good.

HM Treasury has the power to commission an independent review if there is a failure of the system of regulation. It can also commission an audit on the FSA.

An annual open meeting is held once a year in order to discuss the annual report and this meeting is open to the public. An independent complaints commissioner investigates complaints against the FSA and can publish a report and require the FSA to respond. It can also recommend that the FSA pay compensation.

The legislation provides that the FSA is required to consult in public before making any rules. It must consult two statutory panels, namely the practitioners' panel and the consumer panel.

The legislation also provides that a cost-benefit analysis must always be done before any rule is adopted and a statement of purpose must accompany a new rule.

All the FSA's rules and regulations are subject to the oversight of the Competition Board. If rules are restricting competition unnecessarily the FSA's rules can be deferred to the Competition Commission Board and they could overrule a rule.

Individual cases can be challenged in a specialist tribunal, which is part of the court system. However, this is a public forum and has therefore not been used in practice. It does however help to encourage discussion between the FSA and those they regulate.

4 Specific Comments on the FSA

4.1 Comments by the Bank of England

It is possibly too early to assess the Bank's relationship with the FSA since it only started operation in 1997, and officially only in December 2001. The Bank is of the opinion that the relationship has worked well. This is largely attributable to the fact that there are many personal linkages because people moved from the Bank to the FSA. However, the Bank is aware that these personal linkages will eventually erode. There have been attempts to institutionalize the relationship by cross secondments. The Bank recognizes the importance of maintaining good relationships between both institutions. Crucial to this is the continuing exchange of relevant information. This takes place on several levels. The Bank's Deputy Governor is a member of the FSA Board and the FSA chairman sits on the Court of Directors of the Bank of England. At all levels there is close and regular contact between the Bank and the FSA. Information is shared which is or may be relevant to the discharge of their respective responsibilities.

One of the issues raised by the Bank is that the FSA's reporting responsibilities are defined in detail in the Bank of England Act, 1998, but the Bank's responsibilities are not as clearly defined. Therefore it is not always clear what information should be passed on and this becomes a matter of interpretation. Difficulties have been experienced in giving legislative definition to the financial stability role of the Bank. Its monetary policy role is more easily defined. It is therefore difficult to determine whether something falls within the Bank's responsibilities. However, the Bank has not experienced problems in obtaining information as and when they require it.

The removal of Bank Supervision from the Bank of England has required considerable adaptation by the Bank given that amongst other functions it is responsible for maintaining the infrastructure for bank payment systems both at home and abroad in its capacity as the Banker's Bank.

The Bank was of the view that an important consideration in determining whether to adopt the FSA model is whether there are sufficient resources and people with the necessary skills to staff both institutions. Employment in either of these institutions should offer the same career advantages and prestige as the other.

4.2 Comments by Ernst and Young UK Financial Services Regulatory Practice

Ernst and Young pointed out that there are a number of different models of financial regulation. In their opinion, a good alternative to the UK model of a single regulator is the Twin Peaks model (Australian and Dutch model). Under this model, the prudential and conduct-of-business regulations are dealt with by two bodies instead of one.

However, they noted that a Central Bank may not be comfortable with relinquishing the role of prudential supervision in instances where the Bank retains responsibility for the overall stability of the financial system as a whole. This is because the Bank may not get the necessary information from the prudential regulator in order for it to perform its financial stability role. The Regulator has the best source of micro information, but the Central Bank has the best source of market information.

Ernst & Young were of the view that it is easier for Parliament to address the accountability of the regulator if it is split into two. The two bodies have more manageable objectives and it is therefore easier to exercise oversight. In deciding what model to adopt it is therefore important to decide what degree of oversight one wants to have over the regulator. If the two functions are together, as they are in the FSA, it is more powerful than if they were separated.

On the other hand, the existence of two regulatory bodies with limited accountability instead of one, with full accountability could also present a weakness. There will be an area dealing with systems and controls and senior management responsibilities, where it will be difficult to determine who is responsible and accountable for regulating that area.

They noted that when the FSA was first proposed, accountability was a very important concern and it took four years to draft the necessary statute.

In the UK oversight of both the MPC and the FSA is exercised by the Treasury Select Committee which hires economists to advise it.

With regard to how well the relationship between the FSA, the Bank of England and HM Treasury is maintained and managed, Ernst & Young referred to the tripartite Standing Committee where monthly meetings are held between HM Treasury, the Bank of England and the FSA.

They stated that policy in a macro-economic crisis would be co-coordinated between these three bodies and the way in which a systemic crisis would be dealt with will largely be determined by how well these individuals work together.

They stressed that it is very helpful that most people that are now working for the FSA originally worked for the Bank of England. Sir Howard Davies, the Chairman of the FSA was the former Deputy Governor at the Bank of England.

4.3 HM Treasury Comments

HM Treasury felt that a single regulator was necessary because there has been a great degree of convergence and overlap of services offered by insurance companies and banks, which lead to artificial distinctions between regulators.

They went on to say that there is a good reason for separating banking supervision from monetary policy. There is a potential conflict of interests between the conduct of monetary policy and banking supervision. They felt that on occasion, monetary policy is conducted with too great an emphasis on the banking sector, when it should be conducted with the overall economy in mind.

With regard to their relationship with the Bank of England, they said that the development of the Standing Committee on Financial Stability has made the relationship between themselves and the Bank of England closer and less formal with regard to financial stability.

They felt it was very helpful that the Standing Committee on Financial Stability is also able to set up subcommittees on special issues that need to be dealt with.

In HM Treasury's opinion, the existence of a Standing Committee has worked well in policy terms however the administrative arrangements to separate banking supervision from monetary policy are not yet satisfactory. They stressed that cross membership on the Boards of the FSA and the Bank of England are crucial. In terms of accountability the memorandum of understanding is a key element but this has not yet been tested in a crisis.

4.4 McKinsey Comment

Objective

In McKinsey's view determining the objective of having a single regulatory authority is very important. One possible objective is to enhance the soundness and stability of the financial system; another may be the integration of a number of regulators into one institution reflecting the trend towards consolidation within the financial services sector.

The objective one chooses will determine the process that would be followed. An emphasis on the financial stability objective presupposes a more thorough review of the regulatory system and its structure and how a new regulator would need to operate and be organized in order to achieve financial stability. An emphasis on the mere consolidation of regulators would simply be an exercise in institutional integration. This debate has yet to be resolved in South Africa.

 

Level of Stability

In their view it is important to determine what degree of stability one is aiming for in creating a single regulator.

A zero level of failure of financial institutions is not practical, possible or desirable. It would be highly inefficient to obtain such a level because to many regulators would be required. Also, the consumer must assume a certain amount of responsibility for investing prudently. It cannot be expected nor is it practical for a regulator to fully protect a consumer from risk. Instead it is desirable to encourage people to thoroughly check out institutions for themselves, and thus cause bad institutions to fail.

Since regulation does not protect against every failure, the regulator must adopt a risk-based approach to supervision of firms. There are a number of regulatory approaches to choose ranging from a resource intensive approach where supervisory activities are determined through detailed risk assessments of firms, to "remote monitoring" which involves desk-based review of financial information and other regulatory data to identify key risks in groups of similar firms.

Managing the transition process

Aside from the need to set clear objectives on the formation of a single regulator, the question of how the various regulators are merged is also something that needs to be extensively debated. There needs to be management of continuity as well as management of (foreseeable) external events which will coincide with the transition.

The transition to a single regulator is usually a 4 to 5 year process. In the UK, the process took from mid 1997 until late 2001 to complete. They consolidated all the role players in one institution. Only after that was the legal framework put into place.

In Australia they did it in reverse. The establishment of the institution was preceded by a full strategic review called the Wallis enquiry. However, this didn't assist in shortening the time involved. They had the Wallis Enquiry, which was a full strategy review; however, this didn't really help to shorten the time involved in setting up the single regulator. It also took more than 4 years to implement.

6. Recommendations:

A decision to reform the system of a single financial regulator should be preceded by a thorough strategic review involving all role players across all government departments and relevant institutions.

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