The review, conducted by Mark Zelmer, warned that although improvements had been made there was still further work to do and made a series of recommendations for regulators to improve their oversight.
Zelmer added that the Bank of England (BoE) and Prudential Regulation Authority (PRA) should not let their regulatory focus slip in any prolonged periods of financial calm.
He also noted that there was a risk that Open Banking could lead to more runs on banks and building societies, particularly smaller institutions.
Missed chances to intervene
Regarding the Co-op Bank case, Zelmer found the FSA missed several chances to examine the bank in greater detail, particularly around its purchase of the beleaguered Britannia Building Society.
However, he also noted that the FSA acted reasonably in not intervening to halt the bid and acknowledged the unprecedented situation at that time in the UK financial system, and that it would be unreasonable to have begun stress tests sooner.
Key findings of the report included:
- FSA’s stress tests were appropriate and conducted early enough;
- FSA did not interrogate Co-op Bank’s due diligence of the merger with Britannia Building Society in enough detail;
- FSA should have reviewed performance of Co-op Bank’s loan book sooner;
- FSA did not pay enough attention to the refinancing risk of Co-op Bank’s loan book;
- FSA approved the merger despite balance sheet issues;
- FSA supervisors did not check the impact of Co-op Bank’s substantial IT expenditure;
- FSA acted reasonably in not intervening to halt the bid.
Regulation reform recommendations
Zelmer also assessed how the regulatory environment has changed since then and if it was well prepared for further shocks.
As a result eight recommendations were made on how the regulatory environment needed to be amended.
Zelmer signed off the report by highlighting the risk of letting prudential supervision slip away if there was a period of longer-term financial stability.
“I conclude by noting that if the UK experiences a protracted benign economic environment in the future, there is a risk that prudential oversight could fade into the background at the BoE and receive commensurately less executive attention and resources in an institution where the culture is heavily skewed in favour of macroeconomics,” he said.
“The PRA and the BoE may wish to consider how they can best guard against this risk in the future.”
The eight recommendations are:
- The PRA and the BoE should continue to evolve their stress test exercises so that they encompass a broad range of risks to which banks are exposed, and consider how best to incorporate the inherent uncertainty that would prevail as a stress scenario unfolds in real life.
- The PRA and BoE should continue to study how best to use the new resolution tools in systemic situations.
- The PRA should consider how best to balance its objective of promoting the safety and soundness of PRA-authorised firms, with its particular focus on the harm that firms can cause to financial stability, against the interests of individual classes of depositors or creditors that may end up being adversely affected or exposed to more risk in response to the actions of the authorities.
- The PRA and BoE are encouraged to take advantage of the new information on asset encumbrances and consider whether there should be some formal or informal constraints on the extent to which banks and other deposit-taking institutions can encumber their assets in normal circumstances and how best to factor encumbrances into the recovery and resolution plans for these institutions.
- PRA supervisors would benefit from more detailed internal guidance on how to assess the risks to which regulated financial institutions are exposed and the associated mitigants, as well as on how to assess significant transactions of those institutions.
- The Prudential Regulation Committee and the executive management of the PRA should continue to play a leading role in ensuring that supervisory strategies for individual firms proactively take account of emerging regulatory developments.
- The PRA should continue to pay close attention to any attempts by banks to circumvent regulatory and supervisory requirements and focus on the economic substance of transactions, not their accounting treatment or how they are funded.
- The PRA should consider introducing more formal third-party reviews of key prudential information supplied by banking groups through their regulatory data returns.
FCA chairman Charles Randell said: “The PRA and the bank welcome the report, which acknowledges the significant changes to prudential regulation that have taken place since the financial crisis, and notes the very challenging environment in which the FSA operated during this time,” they said.
“The PRA has started working on the recommendations, and will provide published updates.”