The reform of UK financial regulation

Abstract

Since the enactment of the new Banking Act in February 2009, with a new ‘Special Resolution Regime’ at its heart, the debate about how to reform the United Kingdom's financial regulatory and supervisory framework has intensified. A major catalyst for this was the publication of Lord Turner's ‘Review’ in March 2009, which was followed by the Government's White Paper on financial reform in July. The same month, the Conservative Party revealed its own White Paper on the subject, with both the Bank of England and the Financial Services Authority contributing to the debate at frequent intervals. The purpose of this article is to review and analyse these documents and viewpoints before coming to a conclusion about the most appropriate way forward on the domestic financial regulatory front.

Appendices

APPENDIX A

A brief summary of the Banking Act 2009¹⁰³

• The centrepiece is a permanent ‘Special Resolution Regime’ (SRR), which provides the Authorities with a range of tools to deal with banks in financial difficulties. It builds on and refines the temporary tools introduced by the Banking (Special Provisions) Act 2008, which was used to bring Northern Rock plc into temporary public ownership in February 2008, and to resolve Bradford and Bingley plc in September 2008 and the UK subsidiaries of two Icelandic banks in 2008.

• Other measures contained in the Act relate to improvement to the legal framework surrounding the operation of the Financial Services Compensation Scheme; enhancement of the operation of the regulatory frameworks preventing firms from failing; consumer protection; strengthening of the Bank; and new powers for the Treasury to lay regulations to deal with Investment Bank insolvency.

• With respect to the ‘SRR’, provisions relate to stabilisation options (of which there are three), bank insolvency procedures and bank administration procedures. Each of the three stabilisation options is achieved through the exercise of one or more of the ‘stabilisation powers’ – the transfer of shares or the transfer of property.

  • The objectives of the SRR are as follows:

    • — to protect and enhance the stability of the financial systems of the United Kingdom (including the continuity of banking services);

    • — to protect and enhance public confidence in the stability of the banking systems of the United Kingdom;

    • — to protect depositors;

    • — to protect public funds; and

    • — to avoid interfering with property rights in contravention of a Convention right (within the meaning of the Human Rights Act 1980). The Authorities must have regard for these objectives when using, or considering using, their SRR powers, which are also covered by a Treasury ‘Code of Practice’. A ‘Banking Liaison Panel’ will also advise the Treasury on the likely impact of the SRR on banks, their customers and financial markets.

  • Exercise of the stabilisation powers A stabilisation power may only be exercised if the ‘FSA’ is satisfied that the following conditions are met:

    • — that the bank is failing, or is likely to fail, to satisfy the ‘threshold conditions’ (within the meaning of section 41(1) of the Financial Services and Markets Act 2000, which relates to permission to carry on regulated activities); and

    • — that, having regard for timing and other relevant circumstances, it is not reasonably likely that (ignoring the stabilisation powers) action will be taken by or in respect of the bank that will enable the bank to satisfy the threshold conditions. Before deciding whether the second condition is met, the FSA must consult with both the Bank and the Treasury. The Bank may exercise a stabilisation power in respect of a bank transfer to a private sector purchaser or a bridge bank only if it is satisfied that it is necessary to secure the public interest (that is in relation to financial system stability, public confidence in the stability of the banking system and depositor protection). Before determining whether this condition is met, and if so how to react, the Bank must consult with the FSA and the Treasury. Alternatively, where the Treasury notify the Bank that they have provided financial assistance in respect of a bank for the purpose of resolving or reducing a serious threat to the stability of the UK financial systems, the Bank may again exercise a stabilisation power only if it is satisfied that the Treasury have recommended such action in order to protect the public interest and that, in the Bank's opinion, this is an appropriate way to provide that protection. In respect of a bank transfer to temporary public ownership, the Treasury may only exercise a stabilisation power if it is satisfied that one of the following conditions is met:

    • — that the exercise of the power is necessary to resolve or reduce a serious threat to UK financial system stability; or

    • — that the exercise of the power is necessary to protect the public interest, where the Treasury have provided financial assistance in respect of the bank for the purpose of resolving or reducing a serious threat to UK financial system stability. Before determining whether either condition is met, the Treasury must consult with the FSA and the Bank. [N.B. The above arrangements confirm that it is the FSA, sometimes following consultation with both the Bank and the Treasury, that actually ‘triggers’ the use of a stabilisation power under the SRR, although it is the Bank/Treasury that then assumes operational responsibility for the exercise of such powers, following consultation with the other Authorities.]

  • The stabilisation options The three stabilisation options comprise:

    • — selling all or part of the bank's business to a commercial purchaser;

    • — transferring all or part of the bank's business to a company that is wholly owned by the Bank (a ‘bridge bank’); and

    • — taking the bank into temporary public ownership.

• Bank insolvency arrangements The main features of the bank insolvency arrangements are as follows: — a bank enters the process by court order; — the order appoints a bank liquidator; — the bank liquidator aims to arrange for the bank's eligible depositors to have their accounts transferred or to receive their eligible compensation from the FSCS; and — the bank liquidator then winds up the bank.

  • The bank insolvency order Application for such an order may be made to the court by the Bank, the FSA or the Secretary of State on the following grounds: — that the bank is unable, or likely to become unable, to pay its debts; — that the winding up of the bank would be in the public interest; and — that the winding up of the bank would be fair.  The Bank may apply for a bank insolvency order only if:

    • — the FSA has informed the Bank that it is satisfied that the general conditions for the exercise of a stabilisation power are met; and

    • — the Bank is satisfied that the bank has eligible depositors and that Ground (A) or (C) applies. The ‘FSA’ may apply for a bank insolvency order only if:

    • — the Bank consents; and

    • — the FSA is satisfied that the general conditions for the exercise of a stabilisation order are met, that the bank has eligible depositors and that Ground (A) or (C) applies. Finally, the Secretary of State may apply for a bank insolvency order only if satisfied that the bank has eligible depositors and that Ground (B) applies.

  • The bank insolvency process A bank liquidator has two objectives:

    • — to work with the FSCS so as to ensure that, as soon as is reasonably practicable, each eligible depositor has the relevant account transferred to another financial institution, or receives payment from (or on behalf of) the FSCS; and

    • — to wind up the affairs of the bank, so as to achieve the best result for the bank's creditors as a whole. The first objective takes precedence over the second, although the bank liquidator is obliged to begin working towards both objectives immediately upon appointment. Following a bank insolvency order, a liquidation committee must be established, for the purpose of ensuring that the bank liquidator properly exercises the functions prescribed in the Act. This committee shall consist of three individuals, one nominated by each of the Bank, the FSA and the FSCS.

• Bank administration arrangements

  • The main features of the bank administration arrangements are that:

    • — it is used where part of the business of a bank is sold to a commercial purchaser or to a bridge bank in accordance with the relevant provision of the Act;

    • — the court appoints a bank administrator on the application of the Bank;

    • — the bank administrator is able and required to ensure that the non-sold or non-transferred part of the bank (the ‘residual bank’) provides services or facilities required to enable the commercial purchaser or the transferee (the ‘bridge bank’) to operate effectively; and

    • — in other respects, the process is the same as for normal administration under the Insolvency Act 1986, subject to specified modifications.

  • A bank administrator has two objectives:

    • — to provide support to the commercial purchaser or bridge bank; and

    • — to engage in ‘normal’ administration (that is, to rescue the bank as a going concern or achieve a better result for the residual bank's creditors as a whole than would be likely if the residual bank were wound up without first being in bank administration). The first objective takes priority over the second objective, although, upon appointment, a bank administrator is obliged to begin working towards securing both objectives immediately.

  • An application for a bank administration order may be made to the court by the Bank, wherein a person to be appointed as the bank administrator must be nominated and the bank be given due notice of the application. The grounds for said application are:

    • — that the Bank has made or intends to make a property transfer instrument in respect of the bank in accordance with the relevant sections of the Act relating to such transfers to a commercial purchaser or a bridge bank; and

    • — that the Bank is satisfied that the residual bank is either unable to pay its debts or is likely to become unable to pay its debts as a result of the property transfer instrument that the Bank intends to make.

APPENDIX B

A brief summary of the Turner Review¹⁰⁴

• Following a review of the causes of the current global banking crisis, Lord Turner identifies the changes in regulation and supervisory approach needed to create a more stable and effective banking system that the FSA has already implemented or plans to introduce and/or that it is proposing in international fora.

• The former set of recommended initiatives comprise the following: Capital adequacy, accounting and liquidity

  • 1 The quality and quantity of overall capital in the global banking system should be increased, resulting in minimum regulatory requirements significantly above existing Basel rules. The transition to future rules should be carefully phased given the importance of maintaining bank lending in the current macro-economic climate.

  • 2 Capital required against trading book activities should be increased significantly (for example, several times) and a fundamental review of the market risk capital regime (for example, reliance on VaR measures for regulatory purposes) should be launched.

  • 3 Regulators should take immediate action to ensure that the implementation of the current Basel II capital regime does not create unnecessary pro-cyclicality; this can be achieved by using ‘through the cycle’ rather than ‘point in time’ measures of probabilities of default.

  • 4 A counter-cyclical capital adequacy regime should be introduced, with capital buffers that increase in economic upswings and decrease in recessions.

  • 5 Published accounts should also include buffers that anticipate potential future losses, through, for instance, the creation of an ‘Economic Cycle Reserve’.

  • 6 A maximum gross leverage ratio should be introduced as a backstop discipline against excessive growth in absolute balance sheet size.

  • 7 Liquidity regulation and supervision should be recognised as being of equal importance to capital regulation.

    • — More intense and dedicated supervision of individual banks’ liquidity positions should be introduced, including the use of stress tests defined by regulators and covering system-wide risks.

    • — Introduction of a ‘core funding ratio’ to ensure sustainable funding of balance sheet growth should be considered.

    Institutional and geographic coverage of regulation

  • 8 Regulatory and supervisory coverage should follow the principle of economic substance, not legal form.

  • 9 Authorities should have the power to gather information on all significant unregulated financial institutions (for example, hedge funds) to allow assessment of overall system-wide risks. Regulators should have the power to extend prudential regulation of capital and liquidity or impose other restrictions if any institution or group of institutions develops bank-like features that threaten financial stability and/or otherwise become systemically significant.

  • 10 Offshore financial centres should be covered by global agreements on regulatory standards. Deposit insurance

  • 11 Retail deposit insurance should be sufficiently generous to ensure that the vast majority of retail depositors are protected against the impact of bank failure (note: already implemented in the United Kingdom).

  • 12 Clear communication should be put in place to ensure that retail depositors understand the extent of deposit insurance cover. UK bank resolution

  • 13 A resolution regime that facilities the orderly wind-down of failed banks should be in place (already done via the Banking Act 2009 – see Appendix A). Credit rating agencies

  • 14 Credit rating agencies should be subject to registration and supervision to ensure good governance and management of conflicts of interest and to ensure that credit ratings are only applied to securities for which a consistent rating is possible.

  • 15 Rating agencies and regulators should ensure that communication to investors about the appropriate use of ratings makes clear that they are designed to carry inference for credit risk, not liquidity or market price.

  • 16 There should be a fundamental review of the use of structured finance ratings in the Basel II framework. Remuneration

  • 17 Remuneration policies should be designed to avoid incentives for undue risk-taking; risk management considerations should be closely integrated into remuneration decisions. This should be achieved through the development and enforcement of United Kingdom and global codes. Credit Default Swap (CDS) market infrastructure

  • 18 Clearing and central counterparty systems should be developed to cover the standardised contracts that account for the majority of CDS trading. Macro-prudential analysis

  • 19 Both the Bank and the FSA should be extensively and collaboratively involved in macro-prudential analysis and the identification of policy measures. Measures such as counter-cyclical capital and liquidity requirements should be used to offset these risks.

  • 20 Institutions such as the International Monetary Fund must have the resources and robust independence to do high quality macro-prudential analysis and, if necessary, to challenge conventional intellectual wisdoms and national policies. FSA supervisory approach

  • 21 The FSA should complete the implementation of its Supervisory Enhancement Programme (SEP), which entails a major shift in its supervisory approach with:

    • — increase in resources devoted to high-impact firms and in particular to large complex banks;

    • — focus on business models, strategies, risks and outcomes, rather than primarily on systems and processes;

    • — focus on technical skills as well as probity of approved persons;

    • — increased analysis of sectors and comparative analysis of firm performance;

    • — investment in specialist prudential skills;

    • — more intensive information requirements on key risks (for example, liquidity); and

    • — a focus on remuneration policies.

  • 22 The SEP changes should be further reinforced by:

    • — development of capabilities in macro-prudential analysis; and

    • — a major intensification of the role the FSA plays in bank balance sheet analysis and in the oversight of accounting judgements.

    Firm risk management and governance

  • 23 The Walker Review should consider in particular:

    • — whether changes in governance structure are required to increase the independence of risk management functions; and

    • — the skill level and time commitment required for non-executive directors of large complex banks to perform effective oversight of risks and provide challenge to executive strategies.

    Utility banking versus investment banking

  • 24 New capital and liquidity requirements should be designed to constrain commercial banks’ role in risky proprietary trading activities. A more formal and complete legal distinction of ‘narrow banking’ from market-making activities is not feasible. Global cross-border banks

  • 25 International co-ordination of bank supervision should be enhanced by:

    • — the establishment and effective operation of colleges of supervisors for the largest complex and cross-border financial institutions; and

    • — the pre-emptive development of crisis co-ordination mechanisms and contingency plans among supervisors, central banks and finance ministries.

  • 26 The FSA should be prepared to more actively use its powers to require strongly capitalised local subsidiaries, local liquidity and limits to firm activity, if needed to complement improved international co-ordination. European cross-border banks

  • 27 A new European institution should be created that will be an independent authority with regulatory powers, a standard-setter and overseer in the area of supervision, and will be significantly involved in macro-prudential analysis. This body should replace the Lamfalussy Committees. Supervision of individual firms should continue to be performed at national level.

  • 28 The untenable present arrangements in relation to cross-border branch passporting rights should be changed through some combination of:

    • — Increased national powers to require subsidiarisation or to limit retail deposit-taking;

    • — Reforms to European deposit insurance rules that ensure the existence of pre-funded resources to support deposits in the event of a bank failure. • Another set of possible policy initiatives deserving of further debate are then identified. These relate to the following open questions:

  • 29 Should the United Kingdom introduce product regulation of mortgage market Loan-to-Value (LTV) or Loan-to-Income (LTI)?

  • 30 Should financial regulators be willing to impose restrictions on the design or use of wholesale market products (for example, CDS)?

  • 31 Does effective macro-prudential policy require the use of tools other than the variation of counter-cyclical capital and liquidity requirements, for example

    • — through the cycle variation of LTV or LTI ratios

    • — or regulation of collateral margins (‘haircuts’) in derivatives contracts and secured financing transactions?

  • 32 Should decisions on, for instance, short selling recognise the dangers of market irrationality as well as market abuse?

  • The final chapter (Chapter 4) summaries the recommendations, distinguishes those that can be implemented by the FSA acting alone, and those where international agreement is needed, and discusses the appropriate pace and process of implementation.

Source: FSA (2009a).⁵

APPENDIX C

Recommendations of the Walker Review of corporate governance of UK financial institutions

Board size, composition and qualification

Recommendation 1: To ensure that Non-Executive Directors (NEDs) have the knowledge and understanding of the business to enable them to contribute effectively, a Bank/other Financial Instituition (BOFI) board should provide thematic business awareness sessions on a regular basis and each NED should be provided with a substantive personalised approach to induction, training and development to be reviewed annually with the chairman.

Recommendation 2: A BOFI board should provide for dedicated support for NEDs on any matter relevant to the business on which they require advice separate from or additional to that available in the normal board process.

Recommendation 3: NEDs on BOFI boards should be expected to commit more time than has been normal in the past. A minimum expected time commitment of 30–36 days in a major bank board should be clearly indicated in letters of appointment, and will in some cases limit the capacity of the NED to retain or assume board responsibilities elsewhere.

Recommendation 4: The FSA's ongoing supervisory process should give closer attention to the overall balance of the board in relation to the risk strategy of the business, and should take into account not only the relevant experience and other qualities of individual directors, but also their access to an induction and development programme to provide an appropriate level of knowledge and understanding as required to equip them to engage proactively in board deliberation, above all on risk strategy.

Recommendation 5: The FSA's interview process for NEDs proposed for major BOFI boards should involve questioning and assessment by one or more senior advisers with relevant industry experience at or close to board level of a similarly large and complex entity who might be engaged by the FSA for the purpose, possibly on a part-time panel basis.

Functioning of the board and evaluation of performance

Recommendation 6: As part of their role as members of the unitary board of a BOFI, NEDs should be ready, able and encouraged to challenge and test proposals on strategy put forward by the executive. They should satisfy themselves that board discussion and decision-taking on risk matters is based on accurate and appropriately comprehensive information, and draws, as far as they believe it to be relevant or necessary, on external analysis and input.

Recommendation 7: The chairman should be expected to commit a substantial proportion of his or her time, probably not less than two-thirds, to the business of the entity, with clear understanding from the outset that, in the event of need, the BOFI chairmanship role would have priority over any other business time commitment.

Recommendation 8: The chairman of the BOFI board should bring a combination of relevant financial industry experience and a track record of successful leadership capability in a significant board position. Where this desirable combination is only incompletely achievable, the board should give particular weight to convincing leadership experience, as financial industry experience without established leadership skills is unlikely to suffice.

Recommendation 9: The chairman is responsible for leadership of the board, ensuring its effectiveness in all aspects of its role and setting its agenda so that fully adequate time is available for substantive discussion on strategic issues. The chairman should facilitate, encourage and expect the informed and critical contribution of the directors in particular in discussion and decision-taking on matters of risk and strategy, and should promote effective communication between executive and non-executive directors. The chairman is responsible for ensuring that the directors receive all information that is relevant to the discharge of their obligations in accurate, timely and clear form.

Recommendation 10: The chairman of a BOFI board should be proposed for election on an annual basis.

Recommendation 11: The role of the senior independent director (SID) should be to provide a sounding board for the chairman, for the evaluation of the chairman, and to serve as a trusted intermediary for the NEDs as and when necessary. The SID should be accessible to shareholders in the event that communication with the chairman becomes difficult or inappropriate.

Recommendation 12: The board should undertake a formal and rigorous evaluation of its performance, with external facilitation of the process every second or third year. The statement on this evaluation should be a separate section of the annual report describing the work of the board and the nomination or corporate governance committee as appropriate. Where an external facilitator is used, this should be indicated in the statement, together with an indication as to whether there is any other business relationship with the company.

Recommendation 13: The evaluation statement should include such meaningful, high-level information as the board considers necessary to assist shareholders’ understanding of the main features of the evaluation process. The board should disclose that there is an ongoing process for identifying the skills and experience required to address and adequately challenge the key risks and decisions that confront the board, and for evaluating the contributions and commitment of individual directors. The statement should also provide an indication of the nature and extent of communication by the chairman and major shareholders.

The role of institutional shareholders: Communication and engagement

Recommendation 14: Boards should ensure that they are made aware of any material changes in the share register, understand as far as possible the reasons for changes to the register, and satisfy themselves that they have taken steps, if any are required, to respond.

Recommendation 15: In the event of substantial change over a short period in a BOFI share register, the FSA should be ready to contact major selling shareholders to understand their motivation and to seek from the BOFI board an indication of whether and how it proposes to respond.

Recommendation 16: The remit of the Financial Reporting Council (FRC) should be explicitly extended to cover the development and encouragement of adherence to principles of best practice in stewardship by institutional investors and fund managers. This new role should be clarified by separating the content of the present Combined Code, which might be described as the Corporate Governance Code, from what might appropriately be described as Principles for Stewardship.

Recommendation 17: The present best practice ‘Statement of Principles – the Responsibilities of Institutional Shareholders and Agents’ should be ratified by the FRC and become the core of the Principles for Stewardship. By virtue of the independence and authority of the FRC, this transition to sponsorship by the FRC should give materially greater weight to the Principles.

Recommendation 18: The Institutional Shareholders Committee (ISC), in close consultation with the FRC as sponsor of the Principles, should review on an annual basis their continuing aptness in the light of experience and make proposals for any appropriate adaptation.

Recommendation 19: Fund managers and other institutions authorised by the FSA to undertake investment business should signify on their websites their commitment to the Principles of Stewardship. Such reporting should confirm that their mandates from life assurance, pension fund and other major clients normally include provisions in support of engagement activity, and should describe their policies on engagement and how they seek to discharge the responsibilities that commitment to the Principles entails. Where a fund manager or institutional investor is not ready to commit and to report in this sense, it should provide, similarly on the website, a clear explanation of the reasons for the position it is taking.

Recommendation 20: The FSA should encourage commitment to the Principles of Stewardship as a matter of best practice on the part of all institutions that are authorised to manage assets for others and as part of the authorisation process, and in the context of feasibility of effective monitoring should require clear disclosure of such commitment on a ‘comply or explain’ basis.

Recommendation 21: To facilitate effective collective engagement, a Memorandum of Understanding should be prepared, initially among major long-only investors, to establish a flexible and informal but agreed approach to issues such as arrangements for leadership of a specific initiative, confidentiality and any conflicts of interest that might arise. Initiative should be taken by the FRC and major UK fund managers and institutional investors to invite potentially interested major foreign institutional investors, such as sovereign wealth funds and public sector pension funds, to commit to the Principles of Stewardship and, as appropriate, to the Memorandum of Understanding on collective engagement.

Recommendation 22: Voting powers should be exercised, fund managers and other institutional investors should disclose their voting record, and their policies in respect of voting should be described in statements on their websites or in other publicly accessible form.

Governance of risk

Recommendation 23: The board of a BOFI should establish a board risk committee separately from the audit committee with responsibility for oversight and advice to the board on the current risk exposures of the entity and future risk strategy. In preparing advice to the board on its overall risk appetite and tolerance, the board risk committee should take account of the current and prospective macro-economic and financial environment drawing on financial stability assessments such as those published by the Bank and other authoritative sources that may be relevant for the risk policies of the firm.

Recommendation 24: In support of board-level risk governance, a BOFI board should be served by a Chief Risk Officer (CRO) who should participate in the risk management and oversight process at the highest level on an enterprise-wide basis and have a status of total independence from individual business units. Alongside an internal reporting line to the CEO or FD, the CRO should report to the board risk committee, with direct access to the chairman of the committee in the event of need. The tenure and independence of the CRO should be underpinned by a provision that removal from office would require the prior agreement of the board. The remuneration of the CRO should be subject to approval by the chairman or chairman of the board remuneration committee.

Recommendation 25: The board risk committee should have access to and, in the normal course, should expect to draw on external input to its work as a means of taking full account of relevant experience elsewhere and of challenging its analysis and assessment.

Recommendation 26: In respect of a proposed strategic transaction involving acquisition or disposal, it should as a matter of good practice be the responsibility of the board risk committee to oversee a due diligence appraisal of the proposition, drawing on external advice where appropriate and available, before the board takes a decision as to whether to proceed.

Recommendation 27: The board risk committee (or board) risk report should be included as a separate report within the annual report and accounts. The report should describe the strategy of the entity in a risk management context, including information on the key exposures inherent in the strategy and the associated risk tolerance of the entity, and should provide at least high-level information on the scope and outcome of the stress-testing programme. An indication should be given of the membership of the committee, of the frequency of its meetings, whether external advice was taken and, if so, its source.

Remuneration

Recommendation 28: The remit of the remuneration committee should be extended where necessary to cover all aspects of remuneration policy on a firm-wide basis with particular emphasis on the risk dimension.

Recommendation 29: The terms of reference of the remuneration committee should be extended to oversight of remuneration policy and remuneration packages in respect of all executives for whom total remuneration in the previous year or, given the incentive structure proposed, for the current year exceeds or might be expected to exceed the median compensation of executive board members on the same basis.

Recommendation 30: In relation to executives whose total remuneration is expected to exceed that of the median of executive board members, the remuneration committee report should confirm that the committee is satisfied with the way in which performance objectives are linked to the related compensation structures for this group, and should explain the principles underlying the performance objectives and the related compensation structure if not in line with those for executive board members.

Recommendation 31: The remuneration committee report should disclose for ‘high end’ executives whose total remuneration exceeds the executive board median total remuneration, in bands, indicating numbers of executives in each band and, within each band, the main elements of salary, bonus, long-term award and pension contribution.

Recommendation 32: Major FSA-authorised BOFIs that are UK-domiciled subsidiaries of non-resident entities should include in their reporting arrangements with the FSA broad disclosure of the remuneration of ‘high end’ executives as recommended for UK-listed entities, but with detail appropriate to their governance structure and circumstances agreed upon on a case-by-case basis with the FSA. Disclosure of ‘high end’ remuneration on the agreed basis should be included in the annual report of the entity that is required to be filed at Companies House.

Recommendation 33: Deferral of incentive payments should provide the primary risk adjustment mechanism to align rewards with sustainable performance for executive board members and executives whose remuneration exceeds the median for executive board members. Incentives should be balanced so that at least one-half of variable remuneration offered in respect of a financial year is in the form of a long-term incentive scheme with vesting subject to a performance condition with half of the award vesting after not less than 3 years and of the remainder after 5 years. Short-term bonus awards should be paid over a 3-year period with not more than one-third in the first year. Clawback should be used as the means to reclaim amounts in limited circumstances of misstatement and misconduct.

Recommendation 34: Executive board members and executives whose total remuneration exceeds that of the median of executive board members should be expected to maintain a shareholding or retain a portion of vested awards in an amount at least equal to their total compensation on a historic or expected basis, to be built up over a period at the discretion of the remuneration committee. Vesting of stock for this group should not normally be accelerated on cessation of employment other than on compassionate grounds.

Recommendation 35: The remuneration committee should seek advice from the board risk committee on an arm's-length basis on specific risk adjustments to be applied to performance objectives set in the context of incentive packages; in the event of any difference of view, appropriate risk adjustments should be decided by the chairman and NEDs on the board.

Recommendation 36: If the non-binding resolution of a remuneration committee report attracts less than 75 per cent of the total votes cast, the chairman of the committee should stand for re-election in the following year irrespective of his or her normal appointment term.

Recommendation 37: The remuneration committee report should state whether any executive board member or senior executive has the right or opportunity to receive enhanced pension benefits beyond those already disclosed and whether the committee has exercised its discretion during the year to enhance pension benefits either generally or for any member of this group.

Recommendation 38: The remuneration consultants involved in preparation of the draft code of conduct should form a professional body that would assume ownership of the definitive version of the code when consultation on the present draft is complete. The proposed professional body should provide access to the code through a website with an indication of the consulting firms committed to it, and provide for review and adaptation of the code as required in the light of experience.

Recommendation 39: The code and an indication of those committed to it should also be lodged on the FRC website. In making an advisory appointment, remuneration committees should employ a consultant who has committed to the code.

Source: HM Treasury.³²

APPENDIX D

See Table D1.

Table D1 A summary of the main proposals of the government's White Paper on financial reform

APPENDIX E

A summary of the main proposals of the Conservative Party's White Paper on reform

Changes to the regulatory architecture

• The FSA and the Tripartite system will be abolished, with the Bank being given the authority and powers necessary to ensure financial stability.

• The Bank will be made responsible for macro-prudential regulation.

• A new Financial Policy Committee will be created within the Bank, working alongside the Monetary Policy Committee, to monitor systemic risks, operate new macro-prudential regulatory tools and execute the SRR for failing banks. The Committee will include the Governor and existing Deputy Governor for Financial Stability in order to ensure close co-ordination between monetary and financial policy.

• The Bank will be made responsible for the micro-prudential regulation of all banks, building societies and other significant institutions, including insurance companies.

• A new Financial Regulation Division of the Bank will be created to carry out the micro-prudential role, headed by a new Deputy Governor for Financial Regulation. The work of the Division will be overseen by the Financial Policy Committee to ensure close co-ordination between macro-prudential and micro-prudential regulation. The Deputy Governor for Financial Regulation will also be a member of the Financial Policy Committee.

• A new Consumer Protection Agency (CPA) will be created, inheriting the FSA's responsibilities for consumer protection.

• The regulation of consumer credit will be transferred from the Office of Fair Trading to the CPA.

• A single senior Treasury minister will be given responsibility for European financial regulation.

Changes to regulatory policy

• On the micro-prudential front, the following changes to existing policy are proposed:

  • additional capital and liquidity requirements to be imposed to reflect an institution's size and complexity;

  • ‘much higher’ capital requirements to be imposed on high-risk activities, such as large-scale proprietary trading;

  • capital requirements to be used to crack down on risky bonus structures;

  • financial institutions to be forced to prepare ‘living wills’ to assist with their orderly wind-down in the face of insolvency; and

  • the introduction of a ‘backstop’ leverage ratio to constrain bank lending.

• On the macro-prudential front, the following new policies are proposed:

  • the introduction of counter-cyclical capital requirements; and

  • greater central counterparty clearing of OTC securities.

Source: Conservative Party.⁶

APPENDIX F

See Table F1.

Table F1 A comparison of the reform proposals