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Financial Regulatory Governance in South Africa: The Move Towards Twin Peaks

Document Cited in Related
Vincent
DOI10.3366/ajicl.2017.0201
Date01 August 2017
Published date01 August 2017
Pages393-417
INTRODUCTION

The Twin Peaks model of financial system regulation calls for the establishment of two, independent, peak regulatory bodies, one charged with ensuring safety and soundness in the financial system, the other with preventing market misconduct and the abuse of consumers in the financial sector.

For reasons discussed elsewhere,1 of the four models of financial system regulation,2 Twin Peaks is regarded as best suited to this task.

The Twin Peaks model in general – and elements of the Australian version of Twin Peaks in particular – is currently undergoing implementation in South Africa. This article explores issues related to that implementation from the perspective of governance as it is employed in Australia. The article commences with a discussion and an analysis of the historical development of Twin Peaks, followed by a discussion of governance. Next is an analysis of key differences between Twin Peaks in Australia and Twin Peaks as it is to be deployed in South Africa. Finally there are concluding observations.

The article does not canvass the regulatory architecture of Twin Peaks as this has been done elsewhere,3 as have discussions on the need for, and importance of, inter-agency cooperation4 in Twin Peaks.

 HISTORICAL DEVELOPMENT

The historical development of Twin Peaks provides an insight into its aims, which were principally a response to the phenomenon of the ‘blurring of the boundaries’ taking place between traditional financial firms in the United Kingdom. The model, which was first proposed by Michael Taylor in a pamphlet published by the Centre for the Study of Financial Innovation in 1994,5 was aimed, primarily, at the Bank of England. Australia was, however, the first country to adopt this model – a model which is now increasingly being emulated across the globe.

The UK

Prior to the advent of Twin Peaks, the UK's different overseers for conduct and systemic issues in the financial sector were so numerous that it was described as an ‘alphabet soup’6 of regulators. Taylor argued at the time that those arrangements led to conflicts of interest, ‘confusion and damage’:7

Britain's system for regulating financial services, as was once said of its Empire, has been acquired in a fit of absence of mind.8

The UK had a Byzantine system of disparate regulators, with each being assigned a jurisdiction defined by the type of entity being regulated. Contemporaneously, the financial system was increasingly experiencing a ‘blurring of the boundaries’ between different kinds of financial institutions. Banks were combining with insurers and investment banks with stockbroking firms. Added to this was the presence of large, systemically important building societies.9

The combination of these factors was identified as necessitating an overarching financial services regulator, the purpose of which would be to ensure the stability of the financial system.10

This idea – one combined financial services regulator – became the first half of a more substantial proposal – ‘Twin Peaks’. Taylor11 argued for a fusion of the multiple regulators then in existence – regulators charged with banking, securities, insurance and investment management. These regulators included the Bank of England, the Building Societies Commission12 and the Securities and Investments Board (SIB).13

Under Taylor's plan, a new financial services regulator would henceforth assume authority for all deposit-taking institutions14 and, crucially, would no longer simply enforce bank regulations against individual transactions. It would be charged with ensuring the overall stability of the financial system by regulating bank capital and the control of risk.15

Specifically, Taylor envisaged that the bank regulator would address the ‘financial soundness of institutions – including capital adequacy and large exposure requirements, measures relating to systems, controls and provisioning policies, and the vetting of senior managers to ensure that they possessed an appropriate level of experience and skill.’16 The collapse of Barings Bank17 in 1995 provided further impetus18 for the adoption of a single bank regulator.

Under Taylor's proposal a second regulator would then be created, charged with protecting consumers from unscrupulous operators: a market conduct and consumer protection regulator,19 the remit of which would be to ensure that consumers were treated fairly and honestly20 by protecting them against ‘fraud, incompetence, or the abuse of market power’.21 Measures would include restrictions on the advertising, marketing and sale of financial products, as well as minimum fit and proper standards for salespeople.22 In the event of conflict between the two regulators, the Chancellor of the Exchequer would provide a resolution.

According to Taylor,23 this would address four issues simultaneously:

that henceforth a wide range of financial firms would have to be regarded as systemically important;

that sprawling and disparate regulatory agencies be regarded as presenting opportunities for regulatory arbitrage24 and turf battles over jurisdiction;25

that in the ever increasing cases of financial conglomerates, a group-wide perspective on financial soundness would be addressed;26 and

that rare and specialist expertise and limited supervisory resources would be pooled, instead of duplicated by overlapping.

The benefits of Twin Peaks are clear. The proposed structure would eliminate regulatory duplication and overlap; it would create regulatory bodies with a clear and precise remit; it would establish mechanisms for resolving conflicts between the objectives of financial services regulation; and it would encourage a regulatory process which is open, transparent and publicly accountable.27

These examples show why structure does, and should matter, if we wish to create an efficient, effective system of financial services regulation.28

 While Llewellyn29 takes a contrary view, arguing that specialist agencies are easier to hold to their objectives, in Australia the failures that have occurred under each of the two, integrated regulators, have not been due to confusion over objectives.30 Rather, they have been due to a weak enforcement culture which has bedevilled especially the market conduct and consumer protection peak, and to which this article will return

Similarly, Llewellyn argues that integrated agencies are more likely to suffer reputational harm, due to the failures of one particular division within the agency and, as a result, consumer confidence in the regulator may be weakened.31 This argument does comport with the Australian experience, in relation to the manner in which the market conduct and consumer protection agency has handled an ongoing series of financial advice scandals.32

 Australia<xref ref-type="fn" rid="fn33"><sup>33</sup></xref>

The ‘Twin Peaks’ model was proposed by, and implemented on, the conclusion of the Wallis Commission of Inquiry in 1997.34 In the case of the prudential regulator (PA), this replaced 11 separate regulators.35 To wit, Australia separated the market conduct and consumer protection authority – the Australian Securities and Investment Commission (ASIC) – from the bank regulator – the Australian Prudential Regulation Authority (APRA) – and the National Central Bank (NCB) – the Reserve Bank of Australia (RBA).36 Crucially, APRA is not a division of the RBA, whereas in other jurisdictions that have adopted Twin Peaks, the PA has been incorporated as a division of the NCB, and this is the arrangement envisaged for South Africa.37

Under Twin Peaks, the RBA is tasked with, inter alia, overall responsibility for the financial system and as lender of last resort (LLR).38 The Australian model could, therefore, reasonably have been described as a three-peak model, with each peak created as an independent, statutory body.39

In respect of governance, in 1999 APRA moved to a risk-based approach to supervision.40 In 200241 APRA codified its risk-based approach to financial regulation with the introduction of the ‘probability and impact rating system’ (PAIRS)42 and the ‘supervisory oversight and response system’ (SOARS).43

PAIRS is a framework for assessing how ‘risky’ an institution is vis-à-vis APRA's objectives; SOARS determines how officials respond to that risk.44 While PAIRS examines a number of internal risk indices,45 a glaring omission is its failure to provide a formal assessment of industry-wide risks,46 which are particularly germane in an industry susceptible to contagion.

PAIRS differentiates the risk profile of regulated institutions into five categories: low, lower medium, upper medium, high and extreme.47 A similar system was used in the UK prior to the global financial crisis (GFC) and the ensuing collapse of the Royal Bank of Scotland. As a result the efficacy of this ratings matrix is questionable. In evaluating the ratings system used to assess the riskiness of the Royal Bank of Scotland, Hosking states:

The report is a blizzard of acronyms and bogus science: RBS was scored as a ‘medium high minus’[48] risk, whatever that is …49

A key aspect of PAIRS is that it works on a multiplier not a linear scale.50 This results in a higher SOARS scale, which in turn, it is argued, compels a more aggressive supervisory response.51

In terms of the potential impact that a regulated entity might have on the financial system, this is divided into four categories: low, medium, high and extreme.52 This rating is determined relative to the regulated entity's total Australian resident assets, ‘subject to a management override that can raise or lower the impact depending on senior management's assessment’.53 In this regard Black asserts that:

There was little science involved in determining the dividing lines between the ratings, it was more a question of whether the overall result seemed to make sense …54

What this flexibility belies, however, is a lack of coherent methodology. Rather, reliance is made on intuition and supposition. There...

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