UK Financial Institutions Strengthen Accountability

by Morgan Lewis

UK regulators extend the new regulatory framework that governs individual accountability to banking and insurance.

The UK Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) published their final rules on the new banking accountability regime in early July 2015 following a consultation exercise that began in July 2014. The new banking regime is being introduced in response to the perceived shortcomings arising out of the recent banking crisis and as a way of better managing risk in banks.

The new regime comprises three elements: the senior manager's regime (SMR), the certification regime (CR), and the conduct rules. The SMR focuses on individuals who hold key roles or have overall responsibility for a whole area of a bank, and the FCA and PRA will approve them individually. The CR applies to anyone who could pose a risk of significant harm to a firm or any of its customers, such as staff who give investment advice. Those personnel will no longer be required to obtain FCA-approved person status as they do now but instead, regulated firms will be required to certify that they are fit and proper for their roles on an ongoing basis and confirm this annually. The conduct rules represent standards of conduct (such as acting with integrity and observing proper standards of market conduct) that will apply to everyone except those who perform ancillary functions, including personnel not within scope of SMR or CR.

Read our previous LawFlash about this topic in which we discuss in detail the proposals contained in the Joint Consultation Paper[1] published by the FCA and the PRA in July 2014.

Banks, building societies, credit unions, PRA-designated firms, and UK branches of foreign banks (collectively Banks) will be subject to the new banking regime.

Preparing for the New Banking Regime

In its paper, the FCA highlighted the following preparations that Banks will need to make for the new banking regime:

  • The SMR focuses on individuals who hold key roles or have overall responsibility for whole areas of relevant firms. Preparations for the new banking regime will involve allocating and mapping out responsibilities and preparing statements of responsibilities for individuals who carry out senior management functions. Banks will be required to ensure that they have procedures in place to assess their fitness and propriety before applying for approval and, at least, annually afterward.
  • The certification regime applies to other staff who could pose a risk of significant harm to a regulated firm or any of its customers (for example, staff who give investment advice or administer benchmarks). Banks' preparations will need to include putting in place procedures for assessing for themselves the fitness and propriety of staff, for which they will be accountable to regulators.
  • The conduct rules are high-level requirements that hold individuals accountable. Banks' preparations will need to include ensuring that staff members who will be subject to the new rules are aware of the conduct rules and how they apply them.

To implement the reforms, Banks need to carry out a number of steps and put in place key documentation, including a responsibilities map (that identifies the senior managers and their areas of responsibility) and statements of responsibility for each senior manager.

Under the banking reform legislation, where a regulated firm breaches the rules, the relevant senior manager can be found guilty of misconduct—and subject to disciplinary action—unless he or she satisfies the FCA that he or she took reasonable steps to avoid the breach. This is known as the reverse burden of proof, under which senior managers are assumed to be accountable for failings in their area of responsibility unless they can demonstrate that they have taken “reasonable steps” to prevent that failing. The potential sanctions available to the regulators are significant, especially with the introduction of a new criminal offence relating to a decision that causes a financial institution to fail. Because of these high stakes, regulators hope that senior managers will, in turn, be more proactive in holding more junior employees accountable for their actions.

The FCA received a lot of pushback from Banks about these high stakes, so it consulted in March 2015 on further guidance specific to the presumption. That consultation has now closed, and the FCA will issue final guidance later this year, aiming to clearly set out the circumstances in which it would seek to apply the presumption and the steps that a senior manager should take to rebut it.

On 14 July 2015, the FCA published a speech given by FCA Chief Executive Martin Wheatley at the City & Financial conference. In his speech, Mr. Wheatley reminded the audience that, in response to industry feedback, the FCA had removed from scope nonexecutive directors who do not have specific roles in a board. Having warned his audience of the importance of changing the culture and behaviour of the city, Mr. Wheatley resigned a few days after his speech. This is somewhat surprising given that the government was reported to be concerned with Mr. Wheatley’s own behaviour, namely his combative stance against the Banks. It remains to be seen whether there will be a softer approach adopted by Mr. Wheatley’s permanent successor.

Business Implications for the New Banking Regime

The new banking regime is due to take effect on 7 March 2016 and will have significant employment law implications for Banks. To prepare ahead of the commencement date, Banks should put in place the necessary infrastructure to support the changes.

Banks should review and update contracts and policies for senior managers and others who will be subject to the new banking regime. Particular care should be taken in relation to any employee within the scope of the regime but based outside of the UK, because there may be tension between the need to take disciplinary action against an employee for the purpose of enforcing the new banking regime and the need to comply with the local employment law niceties. Other cross-border issues include complying with data privacy law rules when transferring personal data in connection with the new banking regime. Banks may also wish to make changes to bonuses, share options, and other incentive schemes to better align them with the new banking regime.

From a recruitment perspective, it is likely that senior managers will want to be appropriately incentivised in return for exposing themselves to the greater reputational and financial risks of falling foul of the new banking regime. In the global war for talent, Banks may need to pay a premium to compete with lighter regimes in other financial centres.

A related issue is the extent to which Banks will be able to rely on directors and officers liability policies to give these senior managers greater comfort. Even if insurers are prepared to provide extensive cover, Banks may need to think carefully about whether such cover may represent unacceptable moral hazards. The regulators are yet to opine on this subject.

Senior managers are also likely to want a sophisticated information management and reporting system, as well as a dedicated team, to better manage the risks of the new banking regime. This will take time to establish and will likely be expensive.

Banks should also prepare for the possibility that the new banking regime may increase the litigation risk for employment law claims. Because the default position is that senior managers will be responsible for a regulatory failing in their area, they may seek to mitigate this risk by reducing their tolerance of misbehaving or underperforming employees. Furthermore, it may not be so easy to deal with this in a commercial way through the use of settlement agreements because of the regulatory requirements relating to Banks’ need to give or seek references in respect of those employees within the scope of the new banking regime.

Given that a senior manager will be judged by his or her statement of responsibilities, there will likely be a hard-fought negotiation between Banks and senior managers about what should be included, with senior managers looking to limit and qualify their responsibilities to avoid any adverse consequences. Banks will need to adopt a robust approach to ensure that there are no gaps in their responsibilities map.

A significant amount of management time will likely be spent on establishing new systems, including creating and updating the responsibilities map and statements of responsibility, training staff on the conduct rules, and changing a firm’s administrative and information systems.

Banks may lose their ability to be agile and respond quickly to events because senior managers are likely to try to defend their specific areas of responsibility rather than deferring to collective decision making. They are also likely to want to leave a clear audit trail, which may slow down a Bank’s decision making process.

Fair and Effective Markets Review

In his Mansion House speech on 10 June 2015, Governor of the Bank of England Mark Carney commented on the report into the Fair and Effective Markets review (published on the same day) and announced that the new banking regime would be extended to “shadow bank participants,” which could include certain asset management and brokerage firms. This is significant because the Fair and Effective Markets review was commissioned to reinforce confidence in certain financial markets and improve trading practices.

The report into the Fair and Effective Markets review recommended extending many elements of the new banking regime to this wider group of organisations, including the need for senior managers to obtain pre-approval from regulators prior to their appointment (including the need for their responsibilities to be set out in statements of responsibilities), the need for these organisations to certify certain employees as fit and proper, and the need for these organisations to be subject to enforceable conduct rules. Significantly, the recommendations did not go so far as imposing a reverse burden of proof on senior managers, and there would not be any criminal sanctions for causing these types of organisations to fail.

New Insurers’ Regime

In addition to the new banking regime, the PRA published a consultation paper[2] in November 2014 setting out the proposals for the new Senior Insurance Managers Regime (New Insurers’ Regime). The proposals will be introduced to transpose the Solvency II Directive[3] and incorporate elements of the new banking regime within the New Insurers’ Regime.

Insurers, reinsurers, UK branches of foreign firms, insurance special purpose vehicles, and the Society of Lloyd’s and managing agents (Insurers) will be subject to the New Insurers’ Regime.

The New Insurers’ Regime will replace the existing regime for Insurers, albeit in a limited way. Senior insurance managers will require supervisory approval to perform controlled functions or senior insurance management functions. Similar to CR under the new banking regime, Insurers will be required to make their own assessments of fitness and propriety in relation to a wide range of individuals, including those who do not require approval to perform a controlled function or a senior insurance management function but still perform a key function within their firm. The more onerous provisions of the new banking regime (such as the reverse burden of proof for senior managers and the availability of criminal sanctions for causing a financial institution to fail) will not apply to the New Insurers’ Regime.

[1]. PRA CP14/14 and FCA CP14/13 – Strengthening accountability in banking: a new regulatory framework for individuals.

[2]. Senior insurance managers regime: a new regulatory framework for individuals CP26/14.

[3]. Directive 2009/138/EC of the European Parliament and of the Council of 25 November 2009 on the taking-up and pursuit of the business of Insurance and Reinsurance.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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