July 10, 2017

PRA published remarks of Sam Woods, the Deputy Governor for Prudential Regulation and Chief Executive Officer of PRA, which were published for the May 2017 Building Society Association Annual Conference. He discussed the importance of supervision in banking and insurance sectors and examined how supervision differs from regulation. He also highlighted that “financial institutions will always be able to innovate faster than we are able to modify the prudential rulebook,” warning that some innovation is “pure regulatory arbitrage.”

Mr. Woods explained that regulation concerns the framework of rules and legal standards that govern the way in which firms operate whereas supervision is the dynamic pursuit of the relevant authority’s statutory objectives, through oversight of firms’ activities. In his view, supervision without regulation, or vice versa, in financial services would be futile. He added that some innovation is “pure regulatory arbitrage," highlighting that firms innovate to reduce specific regulatory requirements without any commensurate reduction in their risk. He gave a few examples of such behavior that might be problematic, despite compliance with the specified rules. For instance, he mentioned that some banks are seeking out funding that matures just beyond the time horizon used to calculate regulatory liquidity requirements. Another example he gave was about how some special purpose vehicles, derivatives, agency structures, or collateral swaps carry material credit risk, which escapes the detailed aspects of the capital framework. He also exemplified that some insurance firms have sought to amend the existing contracts to extend the (Solvency II) contract boundary and recognize more future profit, as firms cannot recognize future premiums on unit-linked savings policies that do not include any insurance cover or financial guarantee of benefits. In this context, he stated that “Consistent with the PRA’s statutory duty, firms should expect questions and should be prepared to defend them according to our principles of prudence, effective risk management, and adequacy of financial resources at all times.”

 

He observed that “The supervisory approach for banks, building societies, and insurers in the UK has meandered down different paths, at different times—and each at a different pace. Indeed, even when regulation has been laid down in statute, each supervisory agency has taken time to develop and embed its own approach.” PRA supervisors also pay close attention to the emerging trends and potential future risks and supervisors will continue to keep a close eye on the effects of issues on the viability of business models and future strategy for building societies. Finally, he reinforced “that supervision—as distinct from regulation—is vital if we are to ensure that the framework of regulation operates effectively and as intended. Supervisors have an important job to do—defending the reforms put in place following the most recent crisis.”

 

Related Link: Speech (PDF)

Keywords: Europe, United Kingdom, PRA, Supervision, Banking, Insurance, Regulatory Arbitrage