For bank and non-bank financial institutions alike, the current regulatory framework poses distinct and disquieting challenges – perhaps no more so than in the UK, where the added specter of the “Brexit” looms. Akin Gump partners Christopher Leonard and Helen Marshall, deeply experienced and keenly focused on the financial regulatory system, discuss how they are helping clients navigate this unsettled and unsettling landscape. Their remarks have been edited for length and style.
MCC: The Financial Conduct Authority recently saw a leadership change with Andrew Bailey coming over from the Prudential Regulatory Authority. What does this mean for the direction of both agencies?
Marshall: Mr. Bailey has not actually taken up his position yet. That will have to wait until someone is found to take over his role at the PRA. So we’re still anxiously waiting to see what his arrival will mean for the FCA. There’s been a lot of speculation in the media that the announced move signals a softer approach, and that may be the case. In some of his public statements since the appointment, he’s said that he intends to take a more measured approach than his predecessor, Martin Wheatley. Mr. Wheatley became infamous for saying that he was going to “shoot first and ask questions later,” although both he and the FCA did subsequently claim that this was taken out of context and misinterpreted. Mr. Bailey has made clear that he intends to take a more measured, fact-based approach. I hope that we will see that approach. Another new appointment that will be quite important for the direction of the FCA is Mark Steward, the Director of Enforcement of Market Oversight.
MCC: The Bank of England has laid out its approach to stress testing UK banks and building societies, and it signaled plans to cast its net more widely to include non-bank financial institutions, such as hedge funds and asset management firms. How are you helping your UK bank clients meet these compliance challenges? And have you begun a conversation with your other financial services clients about what the future may hold?
Leonard: Since 2008, UK regulators, like their counterparts across the globe, have taken a more jaundiced look at the banking sector, including the rollout of significantly more onerous stress testing to help them better understand the circumstances that might put undue financial pressure on banks. They have also begun to focus on just how large a sum of money is under management by third-party money managers, and under what circumstances that could pose a systemic risk, such as the ripple effects of a collapse in the value of a very large fund. Although there have not yet been any legislative proposals, regulation addressed at the shadow banking sector and at investment funds in particular, including limitations on the use of leverage and the use of stress testing, is very much on the regulatory agenda.
Our advice to clients is to stay in front of the rules and regulations, even though this can be a challenge, as it requires the allocation of fairly significant resources not only to ensure current awareness but also to understand the implications for the client’s particular financial service business.
MCC: The FCA has pledged to consider a firm’s “culture” in assessing whether it passes regulatory muster. How do you go about advising clients on adjusting their cultures to meet regulatory demands when the very term is so ambiguous?
Marshall: I agree that it’s a tough concept to wrap your arms around, much less work toward. And, of course, with the benefit of hindsight it’s always quite easy for a regulator to say, “Well, this went wrong because such-and-such attribute of your culture wasn’t quite right.” In fact, it’s very difficult to set specific and detailed rules for culture, which is partly why I think the FCA feels the need to talk so much about it. One of their key message points is that, without the right tone at the top, the culture you seek to build – of accountability, responsibility, etc. – will never permeate your organization fully and completely.
In talking to our UK-regulated business clients, we emphasize the importance of getting their senior managers to model good, compliant behavior so that others within the organization understand that compliance is as important to senior management as it is to regulators. For example, senior management might consider making the chief of compliance position a board-level or partner-level appointment to demonstrate the value the C-suite ascribes to that role.
While it’s very difficult for organizations to understand exactly what the FCA wants in that regard, we try to help businesses keep on top of the FCA’s fluctuating views on what constitutes good behavior. In addition to formal rule requirements, the FCA, whenever it does a thematic review – which is similar to the SEC’s sweep-type scenarios – produces a report that includes examples of good practice and bad practice. These are very helpful in understanding what the FCA thinks it would like to see in terms of behavior. We make sure clients are aware of those as they’re released.
Leonard: The concept of “culture” within a financial services business is so nebulous that it serves as an easy hook on which a regulator can hang, if not necessarily an enforcement action, then some form of public criticism. Management therefore have to be aware, for example, of what sort of behaviors within the business are rewarded and how they are rewarded – remuneration or promotion? In fact, they have to be hyperconscious of pretty much every business decision and how it might be perceived by a regulator. The regulator expects them to ask themselves, “Am I doing the right thing by our customers?”
MCC: Last year, the FCA continued to use the enforcement stick – including massive fines, such as those imposed on Barclays in the FX case – to discipline and educate the industry. It has not, however, taken much action against senior executives. Do you see that changing?
Marshall: The UK and other regulators, including in the U.S. and across Europe, have been taking certain cases of global significance and imposing some significant penalties on senior management for behavior they consider reprehensible. The FCA has not done very much on that score – and they’ve been quite roundly criticized for it.
Late last year, a report was published regarding the FCA’s failure to properly investigate a number of individuals involved in the failure of one of our banks, Halifax and Bank of Scotland (HBOS). Partly as a result of the criticism in that case and other cases, as well as in the media and among the public, that individuals were not being held sufficiently to account, we are now entering a new phase of regulation in the UK with a new regime that applies to senior managers (currently only in relation to UK-regulated banks and building societies). The new Senior Managers Regime took effect on March 7 and, basically, says that certain senior management functions carry certain responsibilities. The firm will have to provide the FCA with a detailed map of who’s responsible for what, so in the event something goes wrong, it will have a very clear route as to whom it should look in connection with an investigation and possible enforcement action.
That’s a big change, and the plan is that that’s going to be rolled out to cover senior managers in all FCA-regulated firms by the end of 2018. I think the expectation is that it will allow the FCA to bring more cases against individuals, but we’re going to have to wait and see how it works out in practice.
Also on the enforcement front, as I mentioned, Mark Steward has recently been appointed to be the new Director of Enforcement and Market Oversight. He has been quite clear that he wants to take a more open-minded view of investigations. He has said that an investigation should be an open-minded inquiry into whether something has gone wrong or some misconduct has occurred, rather than prosecuting based on a specific view and a route to a particular kind of action. It will be interesting to see how that pans out. Either way, I think we can expect that the FCA will continue to investigate and, ultimately, try and bring cases against senior executives.
Leonard: I would just add that Mr. Steward’s comments represent a fairly significant change in the FCA’s enforcement approach. It’s a change that I welcome, but it will be interesting to see how these comments are reflected in action.
Marshall: I should also add, with reference to the Barclays FX scandal, that the FCA and other regulators had passed all those cases to the Serious Fraud Office about a year ago. Despite a media drumbeat calling for criminal prosecutions of FX traders, the Serious Fraud Office announced just recently that it was discontinuing the investigation, noting that no evidence of criminality was found.
MCC: How are you advising clients to prepare for Britain’s possible withdrawal from the EU?
Leonard: The possible implications of Britain’s exit from the EU are significant for the UK as a whole, not just for financial services clients. But certainly within the financial services world, there are a couple of important points to make. The first is that, were we to vote to leave on June 23, the date the Brexit referendum will be held, the law on June 24 will be exactly as it is today. Nothing will change overnight. That said, it is expected that a leave vote would trigger Article 50 of the Lisbon Treaty, which established a formal process for leaving the EU. That has never happened before, and nobody really knows what it would look like.
Article 50 provides for a two-year notice period in which the exit would be negotiated. There is a school of thought that, during that period, the UK would effectively agree to adhere to existing EU financial services law to continue to have access to the EU’s capital markets. One of the reasons why this is so significant for the financial services industry,
at least in the UK, is that the vast
majority of the nation’s financial services law is derived, in one way or another, from European legislation, directives and regulations.
For example, the Alternative Investment Fund Managers Directive (AIFMD) and the Markets in Financial Instruments Directive (MiFID) –key pieces of legislation for the UK financial services industry – are premised on the idea that an entity is regulated by a European member state financial regulator. If the UK were to leave the EU, that premise would simply not apply to UK businesses. The way in which UK financial services businesses were regulated and able to access EU markets would fundamentally change.
In that two-year notice period, the government will have the monumental task of working out what the UK’s overall relationship with Europe is going to be and then negotiating some form of agreement with the EU, of which financial services legislation would be no small part. As I mentioned earlier, many believe that we would essentially agree to abide by the existing legislation. But it’s entirely possible that the EU would tell us to get lost, shut its doors and close its market to UK businesses. Most likely, the reality will fall somewhere in the middle. That said, there’s very little that a UK firm can do now, other than to hold fast and be prepared to do a lot of work very quickly if there is a leave vote.
MCC: Christopher, you recently wrote a piece taking the EC to task for its overly ambitious timetable for implementing MiFID. How serious a problem is this?
Leonard: The intention of the directive and regulations was to create a single market in financial services across the EU. Since 2008, the EU has spent a significant amount of time looking at and revising both to address their shortcomings. What I said in the article was that the reforms that have been proposed in MiFID are perfectly reasonable, especially the emphasis on transparency in the equities and financial derivatives markets, which was a response to concerns that, in the buildup to the crisis, those markets were insufficiently transparent for regulators to be able to identify and understand the magnitude of the systemic risk and the full extent of the interplay and cross-reliance among financial institutions. MiFID II and related regulations, including European market and infrastructure regulation and the new market abuse regulation, have all been designed to remedy that by effectively closing down the OTC market in certain financial instruments and, in their place, requiring that such business be conducted either on an exchange or, in the absence of an exchange, be reported to a central trade depository.
Although there’s a question mark about whether those reforms were sufficiently forward-looking to capture changes in the way the financial services markets operate, they certainly make sense in terms of addressing what went wrong in 2008. My issue with the reforms is the very firm timetable that the regulators built into the legislation, which effectively required implementation by January 2017. It has recently become apparent to the regulators, who must create the detailed rules to make the directive workable, that they’re in over their heads, and they have decided to postpone the implementation of MiFID II until at least 2018. It hasn’t yet been confirmed by the European Parliament, but the market is now assuming that that is what will happen.
While I think postponement was the sensible, pragmatic thing to do, the problem is this is not the first time that it has happened. Regulators lose credibility when they set aggressive implementation timetables that they themselves are not able to meet. Furthermore, firms feel aggrieved because they know that regulators would be likely to sanction them if they were not ready to adhere to new rules on the day that they were due to come into force and because of the amount of time, effort and money they’ve spent to be ready on day one only to see the project postponed.
MCC: Shadow banking has been under regulatory scrutiny since 2008. How has this scrutiny evolved, and what impact is it having on alternative financing sources?
Leonard: Shadow banking definitely is an area of regulatory focus, particularly as they try to understand the extent to which there is systemic risk in the significant amount of assets under management in Europe but also across the world. So far, that concern hasn’t translated into many significant rules, although we have recently seen the Securities Financing Transactions Regulations, which impose certain transparency obligations around the use of securities financing, such as stock lending, repos (repurchase agreements) and similar transactions. However, a senior European regulator recently made a speech suggesting that the amount of leverage that can be used by investment funds – including hedge funds – should be limited to reduce perceived systemic risk.
However, some EU members have introduced specific regimes for investment funds that lend money. Italy, in particular, recently issued a set of rules that actually liberalize the regime in that country as to how and in what circumstances a fund can lend money. Conversely, in the UK, where restrictions on a fund lending money to the non-retail market are negligible, regulators are considering whether they should rethink their laissez-faire approach
To date, however, I don’t think there has been anything that is limiting the sources of alternative funding, which, by the way, are not just funds but also things like peer-to-peer lending, which are also not subject to much regulatory scrutiny. It seems likely that as those markets evolve, bespoke regulatory regimes designed to manage the risks associated with those marketplaces are likely to be implemented.
Helen Marshall, A partner with the London office of Akin Gump. firstname.lastname@example.org
Christopher Leonard, A partner with the London office of Akin Gump. email@example.com
Published March 29, 2016.