Not long ago, the Bank of England cancelled the annual stress tests of different UK banks this year due to the COVID-19 pandemic. The Prudential Regulatory Authority (PRA), Britain’s prudential regulator for all systemically important financial firms, signalled its willingness to reevaluate the timetable for the new Basel norms on international banking regulation. These relaxations in regulatory scrutiny and planning were based on the health check of UK banks conducted last year, which, according to the Bank of England, “showed that the UK banking system was resilient to deep simultaneous recessions in the UK and global economies that are more severe overall than the global financial crisis, combined with large falls in asset prices and a separate stress of misconduct costs”. Despite the use of dry language, the sheer optimism of this outlook is undeniable, which obviously begs the question of its veracity. More specifically, it is worthwhile to ask: are the UK’s regulatory policies really that good? Can the Bank of England really have that much faith in the stewardship of the financial regulators?

A good starting point for exploring the issues that are thematic and recurrent in the UK’s broader regulatory ideology is its handling of competition and innovation. The Financial Conduct Authority (FCA), Britain’s financial services consumer champion, has been explicitly mandated by the Financial Services and Markets Act 2000 (FSMA 2000) to promote competition and to ensure the removal of market barriers and encourage innovation in pursuance of the same. The PRA also has the competition objective as its secondary objective. The FCA and PRA have worked together to set-up the New Bank Start-up Unit and the FCA has set-up the Regulatory Sandbox for fintech firms. Prima facie, these measures seem to be very successful. Under cohort 5 of the Regulatory Sandbox, 29 businesses have gained entry with 99 applications— the highest so far. The rise of the new banks has been impressive as well: 1 in every 4 millennials is the customer of a challenger bank.

But it would be glib to argue that the rise of fintech and challenger banks represents a true policy success. For instance, the Regulatory Sandbox, rather than being a hub of clinical trials for new financial products, is becoming a way for firms to gain funding and legitimacy before their product is deemed safe. As reported by Financial Times, in the 2018 cohort, around 40% of the Sandbox entrants gained funding just after entry. Moreover, around half of the start-ups that did gain entry had something to do with crypto-currency— a dangerous financial product, to say the least. This should be the cause for grave concern as it exposes that promoting innovation for the sake of innovation creates critical risks for a financial system, after all, payment protection insurance and subprime mortgages were the results of cutting edge innovation.

A deeper analysis of the regulators’ policies on challenger banks exposes the tensions inherent in trying to keep a system both safe and competitive. While challenger banks have grown, they have not really posed a threat to traditional lenders. In 2000, the top six firms had 80% personal current accounts, by 2017 that figure rose to 87%. The reason for this is the high regulatory burden on challenger banks, such as the higher ‘minimum requirement for own funds and eligible liabilities’ or MREL put forth by the Bank of England under the Banking Act 2009. The MREL, as explained by Mark Russell of the British Bankers Association, is necessary to prevent government bail-outs, but it requires smaller banks on an average to have an MREL that is 22% of their risk-weighted liabilities, which is too heavy a burden. So, while the New Bank Start-up Unit is not itself a failure, there is a lack of policies accompanying it that would achieve greater stability through optimal competition.

Another key set of measures that dominates the current regulatory landscape is the change from a ‘light touch’ and ‘tick box’ approach to a more ‘judgment-based’ and ‘outcomes-based’ style of regulation. This kind of regulation ensures that instead of mechanically following certain procedures or protocols that are merely presumed to ensure the safety of the financial system and consumer protection, firms actively engage in adopting strategies and policies which actually achieve the outcomes of better consumer protection and greater systemic stability. This regulatory approach is based on the notion that a one-size-fits-all kind of regulation is ill-suited to the financial and banking sector and that, practically speaking, firms have to be trusted to regulate themselves.

The implications of this approach, which incorporates influences from behavioural economics, is that there is a greater emphasis on banking culture and individual responsibility. In addition, there is an understanding that firms are free to develop their own innovative methods on how to reach certain outcomes. While all of this represents a significant and welcome departure from the pre-2008 approach, problems do exist. Two issues are worth highlighting. First, there is the issue of technology. Regulators lack the technical know-how that firms have and they may find it difficult to assess whether a product is safe. They could be duped by an algorithm supplied by the firm, given algorithms, like human decisions, are made on incomplete data and imperfect logic. Moreover, firms could deliberately seek to mislead regulators using algorithms. As Miranda Mowbray, a former lecturer of computer science at the University of Bristol pointed out in a podcast to The Pangean, algorithms could lead to the next VW scandal. To the regulator, the algorithm may appear regulation-compliant, whereas, in reality, it may not be so. The consequences of a regulator being duped or misled may remain invisible, quietly wreaking havoc until it is too late.

The other issue is that cultural change can be exceedingly difficult. While individual responsibility is important and can go a long way, culture is bigger than any single individual. The attitude people have towards risk and the extent to which they value regulatory compliance and customer protection is something that a regulator has minimum control over. Regulators can ensure management is well-qualified but they cannot stop the idolisation of Gordon Gekko in Wall Street and Jordan Belfort in The Wolf of Wall Street by the whole industry. Moreover, the regulatory culture and banking culture go hand-in-hand. If a regulator arguably starts prioritising innovation for the sake of it by routinely encouraging crypto startups (see above), then it signals its willingness to support potentially dangerous ideas, which inevitably has the effect of engendering a similar openness to exceedingly risky ideas in the banking industry.

The final policy approach worth discussing is the elephant in the room, i.e. stress testing. Indeed, stress testing is a laudable policy measure and practice. Last year’s stress test even involved checking if firms could weather a climate catastrophe. But no policy measure is perfect.

Stress tests are published as part of the financial stability report prepared by the Financial Policy Committee, a committee of the Bank of England that is headed by its Governor, under the Financial Services Act. This report is published after approval in a meeting of the Committee, where the Governor of the Bank of England is required to maintain consensus. The effect of this is that the voices of those who may strongly dissent with the majority’s (likely) positive assessment are suppressed. As we know from past experience, this is a bad idea simply because, to quote Alastair Hudson, “there is as much a need for Eeyore as there is Piglet in macro-prudential regulation”. Besides, the only accountability that the Governor has for the financial stability report is ‘tea’ with the Chancellor of the Exchequer, i.e. a meeting with him, which, undeniably, is not ideal.

All in all, it would seem that the UK’s broad regulatory policies are far from fool-proof and adequately robust. While on the surface they seem to be doing their task of ensuring a stronger, more stable financial system, a closer analysis exposes serious problems brewing beneath the surface. These problems present a strong warning against any sense of complacency and remind us that a lot of work remains to be done. This is not to say that the Bank of England was wrong to cancel this year’s stress tests or that the PRA was wrong in delaying the implementation of Basel IV, it is only to say that the (over) confidence with which regulatory oversight has been eschewed is deeply misplaced. Britain’s regulatory architecture, to put it bluntly, is simply not as strong as it thinks it is. And it better recognise that before things come crashing down once again.