House of Commons - The FSA's report into the failure of RBS

The FSA's report into the failure of RBS - Treasury Contents

3 Lessons for legislation and regulation

The timing of legislation

65. In the wake of the financial crisis, a considerable amount of activity is taking place at the international level to improve capital and liquidity regulation. The Basel III rules, published in December 2010 and revised in July 2011 will, once implemented, considerably strengthen the global capital framework and introduce a new global liquidity standard.[100] It is worth noting that RBS prior to its failure would not have met either the capital or liquidity standards under the proposed Basel III framework.[101]

66. In the UK, with the Financial Services Bill passing through Parliament, and the prospect of further legislation in the form of the draft Banking Reform Bill to embed the proposals put forward by the Independent Commission on Banking (ICB), the UK authorities are now at a pivotal juncture for ensuring that appropriate lessons have been learnt from the crisis and are being incorporated into the new regulatory framework.

67. While a swift passage of the Bills would reduce regulatory uncertainty for financial firms, we highlighted the danger of rushing the regulatory reform proposals in our report Financial Regulation: a preliminary consideration of the Government's proposals in February 2011. We reiterate here our concerns that the legislation would benefit from more careful Parliamentary scrutiny, especially as paucity of time meant that important parts of the Bill were only discussed in short 'stand part' debates in the Commons Public Bill Committee.

Enforcement

68. As Lord Turner notes in the foreword to the FSA Report, bank directors bear responsibilities to the public that go beyond those of other private sector directors:

Banks are different because excessive risk-taking by banks (for instance through an aggressive acquisition) can result in bank failure, taxpayer losses, and wider economic harm. Their failure is of public concern, not just concern for shareholders.

There is therefore a strong public interest in ensuring that bank executives and Boards strike a different balance between risk and return than is acceptable in non-bank companies.[102]

69. We did not take evidence, other than from the FSA, on whether an enforcement action could have taken place; our specialist advisers were specifically excluded from stating a legal opinion on the FSA's decisions as to whether to bring enforcement actions.[103] The FSA Report states that:

For legal sanction to be appropriate, it has to be clear that there was strong evidence that individuals broke specific rules, and/or that decisions were made which were not only mistaken in retrospect but were outside the bounds of reasonableness at the time they were taken.[104]

70. The FSA's enforcement investigations concluded that in the case of RBS, these conditions were not met. The report later notes that:

Enforcement Division does not have the power to take action simply because a failure occurs in an area for which an individual is responsible (i.e. there is no requirement of strict liability). It cannot, therefore, take action against the CEO of a firm simply on the grounds that there were a number of failures at the firm, even though the CEO is ultimately responsible for the actions of the firm.[105]

71.  It is clearly not the case, however, that the criteria for enforcement are so stringent that the FSA is unable to successfully pursue enforcement actions at all. The following table illustrates statistics for the FSA's enforcement activity since 2009.[106]

—  Reporting year (April 1 to March 31) —  2009/10 —  2010/11 —  2011 (as at 31 December 2011)

—  Number of fines —  186 —  215 —  94

—  Total of fines (£mn) —  34.36 —  86.50 —  57.88

—  Public censure only —  6 —  9 —  9

—  Criminal outcome —  3 —  6 —  5

—  Prohibition —  63 —  62 —  35

—  Final notices against individuals —  114 —  121 —  56

72. Lord Turner, in his foreword to the Report, noted that:

Starting four years ago, the FSA's Enforcement Division has transformed its approach to enforcement, pursuing cases far more aggressively. The number of major cases brought has significantly increased: the level of fines has more than trebled in the last three years.[107]

73. In evidence given to this Committee Lord Turner also noted that the current enforcement rules "may bias our enforcement activity to zero in on very specific things that we can prove, even if, seen widely by most reasonable people, they may not be the most important things".[108]

74. The FSA Report describes a series of judgements made by senior executives and the Board at RBS that brought the bank to its knees and ultimately cost the taxpayer a huge amount. It also highlights a profoundly inappropriate regulatory framework that allowed the RBS Board and executives to implement these decisions. It is a matter of considerable surprise to this Committee that nobody (with the partial exception of Mr Jonny Cameron, RBS Executive Director and Chairman of RBS's Global Banking and Markets Division) has been held meaningfully accountable for the failure of RBS.[109]

75. It is deeply regrettable that the current rules bias enforcement activity towards technical breaches to the detriment of attention to the most important regulatory failures. We request that the regulators report to the Treasury Committee on what amendments to the statutory rules and to the general law they believe are desirable in order to improve the effectiveness of the enforcement regime. We also call on the Parliamentary Commission on Banking Standards to examine this issue.

The SIF screening process

76. Despite the failure of enforcement action in the RBS case, there was considerable optimism amongst our witnesses that the Significant Influence Function (SIF) process for screening candidates for the most senior controlled functions within FSA authorised firms was working well, and provided the FSA with a mechanism to ensure that directors of failed banks could be held accountable for those failures, at least to the extent that they should be unable to work in other regulated firms.[110]

77. In the example of RBS, Hector Sants stated to us: "as far as I am concerned, if any of those individuals applied, I would not consider them to be competent on the basis of the track record demonstrated."[111] Sir David Walker was supportive of the use of the SIF process, stating: "I am much in favour of beefing up the SIF process. Maybe the FSA should have even more rigorous interviews of proposed significant influence functions people."[112]

78. Although the current SIF process seems likely to be sufficient to ensure that any director of a failed bank is unable to work at another bank, Hector Sants nonetheless supported the idea of legislative change to make this cast-iron. He stated:

We should change the regulatory regime to [...] ensure that people who have shown [...] serial misjudgment are not allowed to run financial institutions again. That is absolutely my view, so I entirely support Parliament making changes to the regulatory framework so that we can stop people like this working again, without any confusion or any risk that that would not be the case.[113]

79. Mr Knight was also broadly supportive of the use of the SIF process, though he sounded a note of caution about the need for the process to be used with discretion:

You can't become a director of a bank without FSA approval. I think that that is the mechanism to use, and if people are involved with failed institutions then the next time that they, as it were, apply for a job I think that has to be taken thoroughly into account and I think the circumstances have to be gone into. After all, they might have fought tooth and nail to do the right thing at that previous institution. I do not think you can just legislate across the board. You have to look at what the individual actually did.[114]

80. As well as ensuring that directors of failed banks cannot be appointed to other roles within the financial sector, the SIF screening process also has the potential to be used to ensure the performance of directors of banks while they are in situ. One recommendation of the FSA Report is that "where concerns arise, the FSA should make greater use of formal Significant Influence Function (SIF) interviews to assess the competence of senior managers already in post."[115]

81. Mr Knight and Sir David in their written evidence to the Committee noted the particular importance of the responsibilities that a bank CEO delegates to other senior executives and recommended that:

The FSA (and in future PRA) SIF screening process ahead of initial appointment should be complemented by the placing of an explicit obligation on the CEO to attest that he or she is satisfied, on the basis of appropriate and regular performance assessments, that those to whom key responsibilities have been delegated continue to be able to fully discharge them appropriately.[116]

82. For the most senior positions within banks a rigorous approach to SIF screening is appropriate and we commend the FSA's more stringent application of standards relating to SIF screening since the crisis. We recommend that the Government consult on whether additional legislation is required to ensure that directors or other senior executives of failed banks cannot work in other regulated institutions in future, or to make the system more certain. We support the FSA's recommendation that the SIF process be used more vigorously to screen not just applicants for new roles, but also the performance of those already in post.

83. We support the emphasis placed by our specialist advisers on the importance of the authority delegated by a bank CEO. Mechanisms are needed to ensure that the CEO of a failed bank can ultimately be held responsible for failures that occur within their organisation. We recommend that the FSA (and future PRA) examine the introduction of additions to the SIF screening process to ensure that a bank CEO is obliged to attest that he or she is satisfied with the performance of the executive team to which he or she has delegated authority.

Future regulation on sanctions against directors

84. In the foreword to the FSA Report, with reference to the inability of the FSA to bring an enforcement action against individuals at RBS, Lord Turner raised the question: "If harm has been imposed on society, surely someone can and should be held responsible?"[117] If we accept that the FSA, under existing rules, was not able to bring any sanctions against the former employees of RBS, the question, as raised by Lord Turner is: "whether the rules are appropriate: whether the decisions and actions which led to failure should ideally have been sanctionable, and whether we should put in place different rules and standards for the future."[118]

85. While, as noted above, the SIF screening process appears likely to be able to ensure that directors of failed banks are unable to take senior positions in other financial institutions, it is evidently much more difficult to apply punitive sanctions to those directors. Mr Sants highlighted a distinction within the current system about the level of evidence that was needed to bar someone from taking a position in a financial institution versus that needed for the FSA to undertake an enforcement action. He noted:

The threshold for barring somebody's authorisation is lower, is less demanding, than the threshold for enforcement action. While I can say with confidence that, in my opinion, these people will not work again in the regulated sector in an executive role, it does not automatically follow from that that it means we should have been able to take enforcement action. I am entirely in agreement with you: in order to get the type of result that you would like to have, and I think we should have, we need changes to the framework under which we operate.[119]

He noted: "I would like to see the framework under which regulators operate changed so that in future if people demonstrate that type of serial misjudgement, which demonstrates they are not competent, we are able to take action against them."[120]

86. In his foreword Lord Turner suggested that existing laws could be changed to allow sanctions of some sort against directors of failed banks. He proposed the following two possible mechanisms through which this might be achieved:

A legal sanction based approach, introducing a currently absent 'strict liability' of executives and Board members for the adverse consequences of poor decisions, and making it more likely that a bank failure like RBS would be followed by successful enforcement actions, including fines and bans.

An automatic incentives based approach. This would not rely on bringing enforcement cases which proved personal culpability, but would rather seek to ensure that executives and Boards automatically faced downside consequences from bank failure. Options here could include:

- Establishing rules which would automatically ban senior executives and directors of failing banks from future positions of responsibility in financial services unless they could positively demonstrate that they were active in identifying, arguing against and seeking to rectify the causes of failure.

- Regulating remuneration arrangements of executives and non-executive directors so that a significant proportion of remuneration is deferred and forfeited in the event of failure. Regulations of this form have already been introduced for executive directors: they could be strengthened by increasing both the proportion of pay deferred and the period of deferral.[121]

He went on to note some of the pros and cons of these proposals:

A 'strict liability' legal sanction based approach raises complex legal issues relating to burden of proof and human rights. It might in particular cases result in injustice, and might discourage some high quality and high integrity people from being willing to work in banks, given the large personal liability involved.

Automatic sanctions have the advantage of not requiring expensive and contentious legal processes, but may be insufficient to produce a major shift in personal incentives.[122]

87. Sir David also raised some potential problems with the notion of strict liability:

The specific question [...] is the proposition, which would be very serious if implemented, to introduce the concept of strict liability. That is to say that directors would be personally liable where things go wrong. It is a large question for debate. I would have a lot of reservations about that [...] I think there would be a question whether you would get directors ready to serve in those circumstances if their personal vulnerability was so great.[123]

He later noted that strict liability might have the effect of concentrating the mind of bank directors, but that:

You would be concentrating the mind of directors in this country in the way that no other democracy does. This does not exist in the States, in Europe, in Australia, New Zealand or Canada. So it would be a bold departure, which is not a reason for not doing it but it would be very novel.[124]

88. Sir David said that he was more in favour of remuneration measures as a curb on risk taking and on the ability of directors to avoid downside risk:

I am also much in favour of a thing that is currently being discussed in another context, which is in relation to remuneration. We will leave aside all the debate about say on pay and all that, but I do think there is a strong case for more substantial deferment of pay. I would include in that non-executive directors, so that related to some performance measure their fee for 2012 is not available to them, or in some part not available to them, for three or four years, by which time the company will have demonstrated success or not failure. So I think there are things that could be done that would materially help, which are not strict liability.[125]

89. The FSA Report argues that:

The FSA's Remuneration Code now requires firms to ensure that their remuneration policies are consistent with sound and effective risk management, do not encourage risk-taking that exceeds the firm's level of tolerated risk, and are in line with the firm's long-term interests. The Remuneration Code includes guidance that, in designing their long-term incentive plans, firms should take account of the potential for any links to earnings per share to create an incentive to increase leverage to the detriment of the longer-term health of the firm.[126]

90. While the Remuneration Code represents a step forward in thinking about linking remuneration to incentives for appropriate risk-taking, it is open to question whether it goes far enough. There is also a question about how effective the FSA's monitoring of compliance with the Code can be.

91. In relation to the question of whether non-executive directors should be better incentivised to fulfil their responsibilities and be more accountable for failures on their watch, Sir David noted that "if non-executive directors were required to have skin in the game, in the sense of stockholding in any material way, that might be an interesting departure, but if it were the departure I think they would require higher fees."[127]

92. The Treasury published a consultation paper on possible sanctions for directors of failed banks on 3 July 2012, seeking views by the end of September. This sought views on a proposal to introduce a "rebuttable presumption" that the director of a failed bank was not suitable to be approved by the regulator to hold a position as a senior executive in a bank, and on the possibility of introducing criminal sanctions for serious misconduct in the management of a bank.[128] We expect to examine the Treasury's proposals when they are published, and the Parliamentary Commission on Banking Standards may also wish to do so.

93. In financial institutions senior executives reaped large rewards, much of it paid as bonuses inflated by taking on what proved to be unsustainable risks. Yet when the crash came, they proved to be insulated from many of the risks on the downside. A great deal has been written about the misalignment of incentives embedded within the financial services framework. We support attempts to remedy this. Proposals include the introduction of strict liability of senior executives and Board members for the adverse consequences of poor decisions and an automatic sanctions-based approach. The introduction of strict liability, however, would be a major change to the existing legal framework and would require full public debate. The Parliamentary Commission on Banking Standards should examine the various options, including strict liability.

100 Basel Committee on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems, December 2010 (revised June 2011) Back

101 The Financial Services Authority, The failure of the Royal Bank of Scotland: Financial Services Authority Board Report, December 2011, pp 22-23 Back

102 The Financial Services Authority, The failure of the Royal Bank of Scotland: Financial Services Authority Board Report, December 2011, p 9 Back

103 Treasury Committee, Independent Review of Financial Services Authority's report on The Royal Bank of Scotland - Terms of Reference Back

104 The Financial Services Authority, The failure of the Royal Bank of Scotland: Financial Services Authority Board Report, December 2011, p 17 Back

105 The Financial Services Authority, The failure of the Royal Bank of Scotland: Financial Services Authority Board Report, December 2011, p 353 Back

106 Freshfields Bruckhaus Deringer LLP, Bank of the future: FSA enforcement review, February 2012 Back

107 The Financial Services Authority, The failure of the Royal Bank of Scotland: Financial Services Authority Board Report, December 2011, p 8 Back

108 Q 97 Back

109 The settlement with Mr Cameron entailed that he "committed not to perform any significant influence function in relation to any regulated activity or to undertake any further full-time employment in the financial services industry. As part of this settlement, the FSA agreed it would not take any disciplinary action against Mr Cameron. The FSA did not make any findings of regulatory breach against Mr Cameron and he did not make any admissions." The Financial Services Authority, The failure of the Royal Bank of Scotland: Financial Services Authority Board Report, December 2011, p 33 Back

110 More detail on the FSA's improved SIF screening process can be found in the FSA's Consultation Paper 10/3, Effective corporate governance (Significant influence controlled functions and the Walker review), January 2010 Back

111 Q 96 Back