UK's Prudential Regulation Authority Plans to Rely on Own or Market's Judgment

The Telegraph carried an article in which Hector Sants, the individual who will run the UK's Prudential Regulation Authority, laid out his vision for how the PRA would operate.

The Prudential Regulation Authority (PRA), which will take over the supervision of the banking sector from the Financial Services Authority within 18 months, will take a "judgment-based" approach to financial regulation that Hector Sants, the chief executive of the FSA who will run the new PRA, said could have lessened the impact of the financial crisis. 

"Central to this supervisory model is the presumption that regulators cannot rely on the judgment of the firms they supervise, and must take their own view formed from their own analysis about the significant issues which affect the safety and soundness of the firm. Furthermore, where that judgment differs from the firm's management, the regulator must act," said Mr Sants. 

This statement suggests that the pre-credit crisis method of supervisory regulation in the UK consisted of calling each bank, asking if everything was okay, being told it was and then going out to lunch.

Based on my experience with the bank examination model, which the FSA also was using, examiners were physically located in the largest banks every day looking for issues that wold affect the safety and soundness of the firm.  If they found any issues, they would report them both through the reporting channels at the regulator and to the firm's management.

It is at this step that supervisory regulation breaks down.  Management has the opportunity to correct or explain why it is not a problem.  If management does not think it is a problem, they document why it is not a problem.

Then the regulators have to decide if it is a problem worth pursuing based on what the examiner and management have to say.  Who should the regulators trust in making the decision that it is a problem worth pursuing?

In this decision process, the odds are stacked against the examiner and therefore it is unlikely that problems will be addressed.  As Mr. Sants says, regulators relied on the judgment of the firm's management.  This reliance means that the examiner would have to convince a significant number of people at the regulator why the examiner was right and management was wrong (the Nyberg Report on the Irish Crisis also makes this point).

Mr. Sants appears to be proposing that going forward the PRA will assume that the examiner/supervisor is right and it is up to the firm's management to convince the regulator otherwise.  This also does not work.

It cements in the concept of moral hazard. When the regulators have the final say in the management of risk at a financial firm, how can a financial firm be allowed to fail?

It also substitutes the judgment of the regulators for the judgment of the market.  No one believes that the regulators can do a better job of assessing risk than the market.  The common sense test of this is asking the question of who do you think would de a better job of assessing the risk of Citi - a competitor like JP Morgan or the regulators?

Outlining his plans for a PRA, which will be far smaller than the FSA with less than 1,000 staff, Mr Sants said he was hoping to attract "high-quality, experienced supervisors" to the regulator. 

Andrew Bailey, an executive director of the Bank of England who will be Mr Sants' deputy at the PRA, said hiring staff with the clout to deliver judgments on some of the country's largest banks would not mean paying large amounts of money. 

"To just say it is about money isn't right," said Mr Bailey, adding that the type of people who would want to work at the PRA would have to be interested in "policy issues".

Based on my initial read of the BoE's approach to bank supervision under the PRA, I observed that under principle 10, the PRA was adopting current asset and liability-level disclosure so the market could make judgments of risk and return.  These comments confirm that observation.

It makes sense not be be paying large amounts of money to hire the best analysts when financial firms have to disclose their current asset and liability-level data.  This disclosure allows the PRA to leverage off of all the best analysts regardless of where these analysts are employed.

Rather than pay for an in-house analysis that the PRA may or may not use, the best analysts will produce their analyzes but instead will make them available to market participants.  It is the market participants who have the clout and incentive to deliver judgments based on these analyzes on some of the country's largest banks.  This is the very definition of market discipline.