What future for financial regulators?

By Julian Bailey
Business reporter, BBC News

The FSA's boss is appearing before the Treasury Select Committee

This summer's turmoil in the financial markets and the problems at the Northern Rock have raised serious questions about the UK's financial regulators.

Why did no one foresee the funding difficulties at the Northern Rock?

How often were the Financial Services Authority (FSA) and the Bank of England actually talking to each other?

Questions have emerged over the "tripartite" system of financial regulation in which the Bank of England, the FSA and the Treasury have different responsibilities.

The current system was set up by Gordon Brown when he first became Chancellor in 1997.

See a chart of the current system of financial regulation

Under the tripartite system, the FSA supervises the banks, the Treasury is responsible for legislation and the Bank of England for financial stability.

This meant that the Northern Rock was supervised by the FSA but when it ran into trouble it sought help from the Bank of England.

The FSA seems to have used a one-size fits all approach to the amount of cash that it requires banks across a range of different business models to maintain Angela Hayes, Financial Services Regulation Partner at LG

The Bank of England was not keen to inject cash into the financial markets to save the banks' skins.

Would it have felt the same way if it had been closer to the banks?

David Llewellyn, Professor of Money and Banking at Loughborough University, said he has always felt uneasy about the tripartite system.

He prefers the Dutch model of regulation where there is a single regulator who ensures the solvency of the banks and the financial system.

"Is it reasonable to have the Bank of England which is responsible for supervising the system but not the companies that make up that system?" Professor Llewellyn asked.

While the Bank of England has been accused of being unsympathetic to the plight of the banks, the FSA stands accused of giving the Northern Rock an easy time.

Light-touch regulation

The FSA had previously won plaudits for its "principles-based" regulation of the financial sector, under which it has scrapped rules in favour of broad-based principles.

This light-touch regulation has helped to bring business to the City of London, but now it is under attack.

The FSA was responsible for assessing Northern Rock's finances.

In particular, the FSA regulates the amount of capital that banks maintain and their solvency.

"The FSA seems to have used a one-size fits all approach to the amount of cash that it requires banks across a range of different business models to maintain," said Angela Hayes, a lawyer with the City law firm LG, who was involved in the setting up of the FSA.

"It doesn't seem to have taken a different approach with the Northern Rock."

When Callum McCarthy, chairman of the FSA, appears before Parliament's Treasury Select Committee next month he will be asked why the FSA failed to spot the potential problems at the Northern Rock.

Deposit insurance

The final issue for the government to grapple with is the system of deposit insurance.

Customers of the Northern Rock wanted to remove their savings because they knew that they were not completely protected.

The deposit protection scheme guaranteed 100% of the first £2,000 and 90% of the next £31,000.

The Chancellor of the Exchequer, Alistair Darling, has now said that all of the first £35,000 will be guaranteed.

Professor Llewellyn said: "There is an argument that if you create 100% deposit insurance then this creates a moral hazard because it is a disincentive to people to deposit their money carefully."

"But in similar circumstances in the future it's the only thing that is going to stop a run on the bank".

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