Dissertation Paper: Banking Law and the UK

Abstract

This paper is a research paper on the topic – Banking Law in the UK. It focuses specifically, on the banking regulations in the United Kingdom, along with a special emphasis on its effect on the ongoing financial crisis in the economy of the UK as well, on the world. In other words, the consequences of the regulations of the Financial Services Authority on the present recessionary condition of the economy of the UK are discussed. The thesis will link the banking sector with the law aspect and not the financial aspect. The paper is restricted to the banking and financial services industry and its regulation. It talks about the law pertaining to the banking activities in the United Kingdom. It will provide an overview of the law of Britain in relation to the banking field and their resulting effects.

Introduction

The key issue discussed in the dissertation is that, what is the impact of the regulations and standards outlined by the authority governing the financial and banking institutions in the UK. The body that administers the banks and other financial institutions is the Financial Services Authority – FSA. The FSA manages the working of the banks in the UK in a manner, that the banks function in an effective manner and it tries to prevent any failures or losses in the banking industry. In this paper, we are going to talk about the statement – “Supervision cannot and rather, it should not, give a guarantee that there will be no bank failures.”

Firstly, we will have to identify the meaning of supervision, so that, its objectives can be identified clearly and to what level it plays a role concerning the failure of a bank. Although, both the terms can be used interchangeably, it is really important to underline the difference. Supervision indicates the activity that the regulator does after it has offered the authority to the bank to be set up. It takes in the monitoring and investigation of the banks, in order to assure that they conduct their business as per the regulators[1]. The FSA has been authorized to do so by the Financial Services and Markets Act 2000. Before the enforcement of the FISMA, the management and control was done by the Bank of England. Though it is not the regulator any more, yet, it has some involvement.

Problem of Credit Crunch

Before we talk about the effect of the regulations and law of banking on the credit crunch, we will first, understand what the credit crunch is. Obviously, there is a significant relationship between the regulatory authorities and bodies and their laws and regulations for the banks and the entire banking sector. The credit crunch indicates a crisis caused due to banks that are too nervous to lend money, to the customers or to each other, as well. They charge greater rates of interest (wherever they lend money) so that, the risk can be covered.

In the real world, this means more costly mortgages, more high-priced credit cards and problem for those, who save pension and to the investors in the overall stock market, as well, when they fluctuate. In a few worse situations, it also means the repossession and bankruptcy.

When we say recession, many of us think it to similar to the credit crunch. Often, there is confusion between both the terms; however, both of them are different. Recession refers to the two subsequent quarters of negative economic growth. It occurs when the GDP reduces considerably to the level of the full employment[2]. Under recession, there is a considerable reduction in the economic activity disseminated across the entire economy[3]. The condition of recession undoubtedly brings in a huge financial strain, but, it also inspires innovation[4].

In the other words, the credit crunch can either be different from the recession or be a part of the recessionary phase of an economy. But, in any way, recession and credit crunch can not be one and the same. Recently, the disturbance in the economy has been due to the several violations in the financial markets. This has attracted several speculative activities in the market on the causes and effects of the credit crunch. The economy has been in a phase of recession under which there is a tightening of the economy and the inflation rate and the unemployment increases in a significant way. And, this continues for a prolonged period of time[5] .

Limitations of the Study

            Every study is restricted to certain factors and has a few limitations because it requires resources to be put in and the resources are limited[6]. This study relates the banking law in the UK and its affect on the credit crunch. It also has some limitations. First of all, the law is a peculiar aspect that is subject to changes in a particular time according to the conditions of the economy. Especially, the banking law is more susceptible to changes because of the present condition of the economy, which is really fluctuating and weak. Moreover, the resources are limited, the time, funds and human resource assigned to this study have to be considered[7].

Overview of the Chapters

This dissertation offers an explanation of mainly two chapters and out of the two, the second is more important. The first chapter talks about the Regulatory Authority (Financial Services Authority) governing the banking law and the financial activities, of the United Kingdom. This chapter has four key sub chapters including the Structure of the British Banking world, the approach of the UK showing its Background (Bank of England, FSA and major law changes), EC Directive in relation to UK and the Basel Committee in relation to UK. The second chapter is more important, because it relates the banking law to the present financial condition of the Britain; i.e., it discusses the effect of the law and policies and governing bodies on the ongoing financial crisis.

It consists of the relationship of the law to the current situation in the United Kingdom by showing a few examples of banks and financial institutions. The second sub -chapter deals with the example of risk undertaken by the banks including risk related to the mortgage problem. Next, sub- chapter discusses the manner in which the banks are administered and supervised and the role of the FSA in the current scenario and this has been demonstrated through the case of the Northern Rock bank.

Structure of the British Banking world

There has been exchange rate stability in the British banking system, since, the time of more than last two hundred years. This has given it stability of its own and along with it; it has also gained a standard of high trust and integrity. However, keeping in view the current situation and some latest events, the banking regulation of the country has not been very much effective. We have already discussed the failure of banks and especially; the Northern Rock bank and the manner in which the FSA and the Bank of England have managed to assist them. The present scenario has been really bad for the financial institutions and the banks. The recessionary phase is still on in the economy of the whole world and has hit many nations severely. Obviously, it has had an adverse impact on the UK’s banking structure, as well[8].

The banking structure of Britain followed a laissez-faire system, where there was minimum amount of interference of the government and minimally restricted freedom in commerce. It is no more acclaimed as a model for the United States. Both the US and the UK have been managing with the similar problem of credit crisis; though, they are so different in their structure. Nevertheless, both of them have failed. The stocks of the British banks have dropped sharply in the wake of the previous event of the rescue attempt and consequent failure of the Northern Rock bank.

It was a midsize bank whose customers were seen lining up to take out their money. The surviving banks have been struggling to raise funds. Inflation and unemployment have also been increasing significantly and Britain is facing a bear market. The situation might turn out to be worse in Britain as compared to that in the United States. The customers there are more indebted; price increases is significant because the British have to import so much and the financial services contribute towards a bigger part of the economy. Several problems are linked with the financial excesses; however, Britain appears to be examining the loopholes and weaknesses in its financial regulatory structure. Both the US and the UK are filled with default loans and overleveraged institutions. Although, the structure of Britain is quite correct; but its approach to rectify its problems is not at all right. While, the US has followed a wrong structure, as well as, approach[9].

UK’s approach: Background – Banking Regulation in the United Kingdom

Northern Rock was amongst one of the first victims, which suffered big losses. And in year 2008, there has been considerable consolidation in the banking sector of the United Kingdom; this includes the purchase of Alliance & Leicester by Santander and the merger of Lloyds TSB and HBOS. There are several lessons that have been learnt regarding better and effective regulation for the banking industry in the United Kingdom. For an instance, the FSA is already making its prudential supervision stronger and on an international scale, it is looking for filling up the gaps in the present framework, like enhancing the capital requirements for a few credit products and loan commitments, the mortgage origination in the United States and assuring that the investors and rating agencies evaluate new products in a more diligent manner[10].

FSA – Financial Services Authority

There are a few facets of the FSA that are really core to the FSA system. The FSA has turned out to become the only regulator of the financial industry of the UK, after the enforcement of the Financial Services and Markets Bill. The whole purpose of the FSA is explained in the following four statutory objectives that are as follows[11]:

• keeping up the market confidence;

• encouraging public awareness;

• protecting the consumers; and

• decreasing the financial crime.

These objectives and the principles of good regulation have been applied to the law and the particular activities of the FSA those consist of making the rules, preparing and issuing the codes, giving suggestions and guidance and finally, ascertaining the overall principles and policy according to which, the individuals and organizations act. The modern banking law applies the principles and policies to the activities of the regulatory bodies and the authorities[12]. Furthermore, they form a more generalized foundation for public accountability. Market confidence does not mean that there will be zero failure or no failure. FISMA consist of numerous principles of good regulation. They are the efficient use of the resources, management responsibility, balance and easing out the competition and innovation. These principles aim at directing the FSA towards regularization and control that are both Risk-based and Market-based[13].

The FSA does not aim to operate a zero failure arrangement. The firms will fail and the customers will also be mis-sold, although, none of them, will be essentially considered as a failure arising due to some problems in regulation. Operating a zero failure system, would be against the principle of caveat emptor. It will affect the practice of innovation and healthy competition adversely and would also result in unnecessary and unreasonable cost[14]. Their aim is to rectify market failure; instead of protecting the individual instances. As a result, it does not refer to a regulatory failure (FSA). Basically, the objectives of FSA favor the idea of non-zero failure. Above, we have discussed the four statutory ideas of the FSA[15].

The FSA simply aims at maintaining a system that assures a very low incidence of failure of regulated firms and markets, particularly; the failures, which would have a significant effect on the public confidence and market reliability as is coherent with the upkeep of the innovation and competition in the markets. As a result, this needs a careful analysis of the possibility of a collapse and its probable effect on the financial system. There is an obvious risk that the very subsistence of a regulatory system, may result in expectations by the people, for a greater degree of protection than what is desired[16].

As per the objective of the public awareness, the FSA will seek to describe that what it aims at attaining in the entire financial system. This is so, because when there are failures, the damage to the market confidence is at a minimum. Therefore, in accordance with the FSA, sustaining the confidence in the markets does not refers to that planning for the prevention of all collapses or lapses in conduct, in the financial system. The nature of the financial markets is extremely volatile and as a result, a ‘zero failure’ regime is not possible. Market confidence is central to the success of any financial system.

Any such arrangement would be very troublesome for governed firms and would not agree with the legal objectives and principles. It would be likely to harm the economy all together and would be rather not viable from the point of view of the cost-benefit; it would repress competition and innovation. Moreover, it would be conflicting with the relevant responsibilities of the management and of the customers, for their own activities. Substantial dangers would come up, if the customers or the market participants suppose that no organization would ever be permitted to collapse; this would reduce the incentive for individuals or firms to take reasonable care in evaluating the risk attached with their financial decisions. Nevertheless, the FSA will look for ways in which the effect of the failures on the market confidence can be minimized[17].

Bank of England

The Bank of England has encountered the problem of the amount of fund assistance to be given to the markets in Britain, without permitting the banks, to directly take the advantage. The similar situation also has prevailed in the Europe and the European Central Bank – ECB also have been facing this situation. Thus, this crisis has also spread out to the entire Continent of Europe, including the Great Britain[18].

A major change was made in the policy regarding the banking regulation in the UK by the Bank of England Act 1998 and the Financial Services and Markets 2000. It adopted a radical approach and included the regulation of the traditional activities of banking in a broader range of the regulatory framework for the financial services starting from the derivatives and shares to the mortgages and insurance[19]. A new regime of FISMA has been adopted and its assessment has also been done in comparison with the historic approach of banking regulation and the supervisory approach of the Bank of England[20].

The administrative techniques of the bank of England have been qualified as qualitative, flexible, practical and having a tendency to rare failure. In its corrective function (the Bank itself may balk to assume the term “enforcement”), the Bank has decided upon to act with carefulness and judgment, considering that to publicize the troubles of an individual organization may endanger its prospects of recovery and generate prospects for logical consequences.

The introduction of a statutory setting to administer the banking management procedure could hardly change the fundamental style of the Bank[21].

On the contrary, the relationships established between the SROs and their respective memberships have concentrated mainly on an organization’s observance function, usually, together with a line of communication into the department of finance for a periodical reporting of the financial resources. Considerably, the way in which those relationships developed has been a follow-up of the dictatorial regulatory role allotted by the Financial Services Act 1986 to the SROs, containing the continuous reviews of the abidance of a corporation with a set of rules ruling the relationships of the client and fulfilling a set of dictated financial resources tests[22].

And the duties designated by law to the SROs are consecutively an offshoot of the fundamental procedure for shielding the investors. A further severe difference rests in the methods by which, the banking and securities managers and supervisors arrange their implementation processes. The SROs have comprehensive and thorough, prescriptive models of technical rules regulating their tribunal schemes and a significant armory of available enforcement sanctions to enforce. In the evaluation of the comparative weaknesses and strengths of the distinct enforcement cultures, it appears to be undesirable to assume that review at the level of principle, at which the absolutes tend to reign. It is implicit that an authoritarian enforcement procedure will be dependant on the restraints of the public law and the superseding requirement for giving substantial justice to those jammed in the process[23].

Firstly, it seems that the dependability on an informal, non-normative ordinance might be sensible and successful just in some limited situation.Secondly, the conditions modify and market perceptions also change. It does not have to pursue that what has been attained previously will persist as an objective to be achieved in the future.In the third place, although, it is usually observed that practical, informal enforcement measurements hold the benefits of reasonableness, flexibility and speed, it does not mean that those worthy features are outside the reach of a cautiously made and reasonably carried out prescriptive enforcement system.Fourth, it is likely that higher business standards can be attained by means of a non-prescriptive informal and flexible regularization, because, then the obligations do not have to be determined in exact legal terms and the failures to meet the terms do not require establishing in regulatory tribunals through an adversarial procedure.Major Law Changes

In the light of the collapse of the Northern Rock, the government has anticipated sweeping modifications to the insolvency system of the United Kingdom, since; it is relevant to the deposit-taking financial institutions. Though, the changes relating to the protection of the depositors are possibly essential to re-instate and encourage confidence in the banking arrangement, however, the suggested reforms to the insolvency law are too sweeping. The existing arrangement of the administration is sufficient to handle the insolvency of a big bank with no extensive changes[24].

There are several proposals by the government. The reform of the bank insolvency system is just one face of the proposals given by the government. The modifications of the regulation of liquidity, the securitization markets, regulatory oversight and co-operation of the Tripartite are all important components of the response of the government. But, even if all those reforms are executed efficiently, the failures of the bank might yet take place and widespread reforms to the insolvency administration have been proposed by the government to manage a bank failure[25].

At present, the insolvency of a bank governed in the UK would be administered under the Insolvency Act 1986. A branch of a bank in the UK governed in another jurisdiction in the European Economic Area would also be conditional on the Credit Institutions (Winding Up and Reorganization) Regulations 2004 (Credit Institutions Regulations). Those regulations forbid the beginning of most restructuring and bankruptcy procedures regarding the branches of credit institutions of the UK with their head offices in the other EEA authority[26].

The Financial Collateral Arrangement (No 2) Regulations 2003 change the insolvency law concerning the financial collateral preparations, so as, to make such arrangements enforceable, in spite of the insolvency of the provider of the collaterals. They relate to the measures that offer for cash or financial instruments to be given as collateral for obligations. For instance, it is not permitted for an administrator to manage the assets dependant on a floating charge on the financial collateral qualifying as a security financial collateral agreement[27].

The cessation on the enforcement of security against a company in administration is not relevant to the implementation of a security financial collateral arrangement. Where there is a head office of a bank in the UK, the drawbacks for applying IA 1986 were made clear in the Northern Rock situation. After an insolvency practitioner is appointed, the business of the bank would be stopped and its accounts would be frozen at the same time, as the insolvency practitioner took charge of the situation and evaluated the bank’s assets and liabilities[28].

This would call for a ‘freeze’ on the withdrawals by the depositors, who would be ranked as unsecured creditors. Moreover, the automatic set-off as per the insolvency rules 1996 (r 2.85 regarding administration (on notice of dividend) and r 4.90 with regard to liquidation) would operate to automatically set off any amounts, the depositors owed to the bank against the amounts deposited with the bank. This may result in not just defaults on part of the customers under other credit contracts and with service providers, although, substantial hardship for those, not having any liquidity[29].

The experience of those depositors could probably promote the depositors at other banks to take back their funds to avert the similar fate, resulting in extensive bank runs and significant insolvencies. When known that the considerable hardship caused due to the failure of a key retail bank and the risk of the financial stability of the regime, the government will be beleaguered to avoid the situation of the crisis, as in the case of the Northern Rock scenario, by offering the assistance to the bank and support to the depositors. As a result, the risk of the bank insolvency is presently borne by the taxpayer[30].

Reducing the Impact of Failure

The government has not recommended that the bank failures should not be possible at all; instead they should be controlled in a way that the cost is borne by the suitable parties, which in the view of the government should be big depositors, creditors and the stockholders. The small depositors’ and taxpayers’ interests need protection. To that extent, it has been recommended by the government that some reforms should be made in the existing compensation system. The ‘Financial Services Compensation Scheme’ would more effectively guard the depositors in the occasion of a bank failure. Apart from these reforms, the government has also suggested radical alterations to the insolvency system, since; it is related to banks and numerous new tools that would be accessible before the insolvency[31].

The Special Resolution Regime

The Special Resolution Regime or the SRR refers to a bundle of many proposed reforms, which will be relevant to the pre, as well as, post insolvency. A new system for bank insolvency is just a single component of the SRR; however, it is worth testing and probing the complete package of modifications and reforms. Inspiration has been taken from the systems in other countries, especially, from the Federal Deposit Insurance Corporation in the United States. The stated objectives of the FDIC include the avoidance of the contagion to other banks; obtain speedy payouts for the depositors and to sustain value in a bank franchise for improving the chances of the private sale[32]. The tools proposed by the government to generate in the range of the new SRR consist of the following:

Trained and accelerated transfer of banking business to the private buyers;Transfer to a bridge bank that is owned and managed by the public sector enterprises;Recruitment of a restructuring officer to implement the SRR;Procedure for the insolvency of a specialist bank.Now, a new procedure has been proposed for the insolvency of the banks; this is based on the present current insolvency framework, having the key objective of easing the claims of the depositors as per the Financial Services Compensation Scheme. The Tripartite decided to reject the creation of a preference for depositors. The claims of the depositors would continue to grade as unsecured claims; however the FSCS would guarantee them. Now, the FSCS would take a task of those claims and demonstrate the insolvency of the bank. It is recommended that the Tripartite would regulate the entry of the bank in the procedure of insolvency and that a notice of 14 days would have to be given to the three-party prior to any enforcement action by a creditor. This is to give some time to the Tripartite for considering whether one of the other SRR tools should be executed in preference to the process of bank insolvency. The Tripartite could apply without notice basis for an order starting from the procedure of bank insolvency, where it ascertains that the bank insolvency procedure is the best alternative[33].

Emergent trends in bank supervision

There have been two key trends that have arisen in the supervision of the banks in the United Kingdom. The first trend relates to the use of the statutory law in the administrative procedures and the second trend is concerned with the role played by the auditors of the banks in that process. It is argued that the Bank of England set up a flexible and co-operative method for the bank supervision. It is a fact that the government of the UK frequently resorts to law to further its objectives of the policy. The regulation of the activities of the banks in the United Kingdom was originally affected completely on a non-statutory basis. Then, discussing the second trend, the banks should also always hire auditors. Till in the recent times, the duties and rights of the bank auditors like the duty of observing the confidentiality of the client were like the duties of the ordinary auditors of the company[34].

EC Directive in relation to UK

European Union is a unique economic and political affiliation amongst the 27 democratic European nations. The chief aims include peace, freedom and prosperity for all of the 498 million citizens in a world that is more safe and fair. In order to fulfill its aims and objectives, the EU countries have established three authorities to run the European Union and adopt its law[35].

It works through three major bodies that are as mentioned[36]:

The European Parliament (constituting the people of Europe);The Council of the European Union (presenting national governments);The European Commission (representing the common EU interest).The European banks are however, principally, oriented on a national scale, that the number of internationally oriented banks is not large and that the global actions are about, as large as, the European actions. In addition to this, the European activities of these banks are revealed to be flocked, showing several local orientations. In the dearth of substantial pan-European banks, this differentiated market structure demands a custom-made approach to regulation in Europe. This recommends establishing on the model for combined management[37].

Two key banks of the United Kingdom bailed out by the government of Britain have presented their restructuring plans to the regulators of the European Union for seeking their approval over the same. The European Commission is examining the restructuring proposals from lots of lenders to make sure that the aid given by the state to the banks does not deform the competition in the European Union. Nowadays, the regulatory focus would move towards the British lenders after the EU Executive cleared such plans from Germany’s Commerzbank (CBKG.DE: Quote, Profile, Research) and WestLB[38].

The British government took up a 70% stake in RBS and 43% of Lloyds as part of a taxpayer-funded bailout worth 37 billion pounds in the past year after both the banks were hit by the losses on credit-backed assets. In order to follow the anti-trust rules of the European Union, both the banks have to introduce restructuring plans to abide by the EU antitrust regulations. The new EU rules could see the lenders forced to sell big parts of their assets and delay on takeovers.

People are much more grateful of a few significant benefits of the EU membership than previously suspected. In reality, most of the people have the same opinion that membership has[39]:

Improved opportunities for business (78%)Profited exporters (68%) and consumers (63%)Better working conditions (51%)Larger number of opportunities to live, work and study in the other nation (79%)Additionally, one out of eight of those polled (12%), said that they had lived in other member state for studies or job; 16% had purchased goods like car from another nation of the European Union and property has been purchased by a 4%. Taking into account the future direction of Europe, the highest priority for action from the European Union was struggling against the climatic change (43%) pursued by energy conservation and alternative sources of power (28.6%) and creating jobs, encouraging economic growth (15%)[40].

Basel Committee in relation to UK

In the year 1974, the Regulators of the Central Banks, of the Group of ten countries established the “Basel Committee”. A statement of principles was issued by this committee on banking regulations and supervisory, to key out weakness of the financial sector to be misused by the criminals. For keeping the use of the banking sector mainly for the purpose of concealment, the issue of principles’ statement was a significant step, because it laid out major principles, which all the banking institutions should follow[41].

The principles include identification of consumers, cooperation with lawmaking, accordance with general laws & regulations and ethical standards. In banking management, this committee