The Treasury proposes a new framework for financial regulation

The Treasury has just produced a paper outlining a new framework for financial sector regulation. The paper proposes three new innovations:

• A new Financial Policy Committee (FPC) will be established in the Bank of England, with responsibility for ‘macro-prudential’ regulation, or regulation of stability and resilience of the financial system as a whole;

• Micro-prudential (that is, firm-specific) regulation of financial institutions that manage significant risks will be carried out by an independent subsidiary of the Bank of England, the Prudential Regulation Authority (PRA);

• Responsibility for business regulation will be transferred to a new regulator - the Financial Conduct Authority (FCA). The FCA will have responsibility for conduct issues across the entire spectrum of financial services.

The strategy has at least two commendable features; the Financial Services Agency will be, for all practical purposes, abolished. As such, we are witnessing a rare example of insitutional accountability. The FSA's failure is being justly punished.

Second, the Bank of England is now back in the driving seat. It has primary responsibility for overseeing the financial system. In practical terms, it is a return to the pre-1997 position, thus unwinding the nightmarish Brownite experimentation in financial sector supervision.

However, on more substantive regulatory reform, the strategy is disappointing. Instead of promptly pushing for higher capital and liquidity requirements, the strategy has placed its trust in Basel III - a multi-lateral approach to enhancing financial sector regulation.

We are likely to wait a long time for an international consensus for tighter capital and liquidity requirements. It would be far better to circumvent these tedious discussions, act unilaterally and decisively strengthen our national regulatory framework. The government should propose higher mandatory capital and liquidity requirements.

Bankers will inevitably complain that tighter regulation will reduce UK financial sector competitiveness. There are two ripostes to this argument. First, the UK is excessively dependent on financial services. We need to diversify, and some downsizing of the city of London would be no bad thing. Second, tighter regulation might have powerful reputational effects, strengthening UK bank balance sheets, which might limit some of this loss in competitiveness.

In any event, tighter regulation is needed in order to avoid a repetition of the 2008 financial crisis. The sooner the government acts to constrain reckless banking practices, the better.