While it is absolutely right that we look at the appropriateness of regulation to identify where rules have become blockers rather than enablers, duplicative, out dated or where the cost-benefit trade off has erred towards cost, it’s important to approach the task with clear thinking.
The law of three
Not all regulation is the same. Some rules should be protected, others need updating, and some may be ready to go. We can group regulation into three categories.
Regulations that protect market stability or consumers
These rules are often responses to past crises or serious consumer harm. Even if they feel burdensome, they play a vital role in keeping the financial system safe and fair. For example, the rules put in place after the 2008 financial crisis to make banks stronger should generally be kept. As the Bank of England Governor Andrew Bailey has said, stability and growth are not opposites, you can’t have sustainable growth without a stable financial system.
The opportunities for change in this category are arguably smaller, that being said, there is a tendency for prudential rules to create cliff edges and to distort incentives. It’s important that we continue to review these rules to ensure they are proportionate to the risk and continue to support Financial Institutions (FI’s) as they grow.
Regulations that can promote growth
Some areas are under-regulated, and this lack of clarity can actually hold the UK back. A good example is digital assets such as tokenised assets and stablecoins. There are currently no clear rules around how digital assets should be held, traded, or lent. This uncertainty has made large FI’s hesitant to get involved. New, thoughtful rules here could support innovation and unlock growth and thankfully we have seen momentum in recent weeks from government and the Financial Conduct Authority to bring about a comprehensive regime.
Artificial intelligence (AI) is another example, rather than having guardrails specific to the risks of AI, FI’s are instead applying requirements borrowed from other areas including rules around operational resilience and management of critical third parties. While these may be right for now, as AI use cases develop in complexity rules may need to be developed.
Regulations that act as unnecessary barriers
Some existing rules may be outdated, overly cautious, or not suited to the current economy. These are areas where the risk of harm is relatively low and where lifting or simplifying rules could support growth without significantly increasing risk.
Reform here is about striking the right balance, removing friction while still protecting key interests. Recent examples of low hanging fruit here include regulatory reporting where it has become outdated and duplicative. Other areas include overly complex scoping rules for which rules apply to which customer groups or FI’s, for example having several definitions for small and medium sized business.
Choosing between principles and detailed rules
There’s been growing debate on whether regulators can rely more on high-level outcomes and principles rather than lengthy rulebooks. For example, following the FCA’s implementation of the Consumer Duty, some are calling for simplification of the existing rulebook.
But what’s still missing is a clear set of guiding principles to help decide when detailed rules are necessary and when principles are enough.
Here are some practical considerations that can help guide which type of regulation is right in a given situation:
Is the risk dynamic and fast-moving?
In fast-changing areas like tech, crypto, or fintech products, detailed rules can quickly become outdated. Principles may offer more flexibility and help future-proof regulation.
Do legal outcomes depend on the rules?
In areas where consumer harm may end up in court, like insolvency or safeguarding client money, legal certainty is vital. Detailed rules are often needed to give clear expectations and support enforceability in court.
What kind of supervision and enforcement works best?
Interestingly, many of the FCA’s biggest fines have relied on breaches of broad principles, rather than specific rule breaches. Principles can be powerful tools for holding firms accountable when their behaviour falls short, even if they technically followed the rules.
How significant is the conduct risk?
Think about the nature of the product or service, is it complex or high-value? Is the customer relationship long-term or one-off? Are the customers potentially vulnerable?
For high-risk areas like pensions, investments, or insurance, especially where customers rely heavily on advice, more detailed rules may be needed to set clear boundaries.
What do smaller firms need?
For start-ups and new entrants, clear and detailed rules can provide certainty and reduce the cost of legal advice. Too much reliance on principles can make it hard for smaller FI’s to know what’s expected.
Could the courts or ombudsman reinterpret things?
Without clear rules, there’s a risk that courts or the Financial Ombudsman Service (FOS) might apply principles in unexpected ways, leading to unintended outcomes. The recent example of redress in motor finance shows how this can become a serious and costly issue.
Exploring unintended consequences
As part of the process of understanding whether to introduce or reform rules we often do not spend enough time considering whether the actual outcomes of a proposal are likely to match the intended outcomes of the change. The way in which FI’s react to rule changes is incredibly important to consider, from product design and pricing to capital investment decisions, to retrenchment or broaden of a service offering and importantly impact on risk appetite. As regulators are setting out proposals they need to consider a range of factors.
How do rule changes encourage competition?
Do they level the playing field or tilt the advantage to incumbents. Rules that set capital or liquidity requirements often have broader consequences for how firms compete, so to do rules that increase the levels of regulatory and compliance risk FI’s face.
What are the second order effects?
For example, where regulatory hurdles are set too high what are the risks of activities moving outside the sector. There are some indications of this occurring through the rise of private equity and private credit firms, where there is greater appetite to take on some of the lending activities traditionally undertaken by regulated banks.
How do rules impact cross-subsidization?
Particularly in retail banking certain customer groups, high net worth individuals, larger business often help to lower the cost of serving less profitable customer groups by supporting the economies of scales of a bank. This might be through larger retail deposits, higher fees and charges or high margin business.
However, there are other forms of cross-subsidization that are arguably less fair, for example where loyal customers are charged more for the same product or service as new customers. We need to be clear when setting rules, which forms of cross-subsidization are appropriate and how that dynamic changes as FI’s implement new rules.
