Regulatory forbearance looms as next big supervisory risk for financial giants

September 9, 2011

By Susannah Hammond

LONDON/NEW YORK, Sept. 9 (Thomson Reuters Accelus) – Regulatory forbearance is not a concept that has hit many headlines. It is, however, emerging as an underlying theme in publications by a range of bodies, from the International Monetary Fund (IMF) to the European Union and beyond. Regulatory forbearance is not about supervisory incompetence but, rather, the potential for a fully briefed regulator to decide not to intervene. There may be many legitimate occasions when non-intervention is the right call but, when judged with the benefit of hindsight, more supervisory interventions, made sooner, could have ameliorated some of the worst of the issues arising out of the financial crisis.

As Bank of England governor Sir Mervyn King stated, taking away the punchbowl when the party is in full swing is never an easy decision to make. Regulators, however, must be both capable and willing to take tough interventionist action. Regulators making such difficult decisions need to be assured that they have the backing of the international financial services community, the support of their domestic political masters and, perhaps to a lesser extent, the understanding of the public.

That is not to say that financial services firms cannot fail. Firms must be allowed to fail, but it is the impact of that failure on the wider economy which is critical. It is a message that will need to be repeated often, but regulatory intervention to allow the orderly failure of a firm without causing systemic failure in the marketplace should be seen as a successful supervisory action, not regulatory incompetence.


The supranational bodies have started to factor the scope for regulatory forbearance into their approach, and the IMF has gone as far as trying to model the behaviour. In working paper No. 11/193, released last month and titled “Systemic risk and optimal regulatory architecture”, the IMF considers that regulatory reforms to date have overlooked the incentives for regulatory agencies’ forbearance and information sharing. The model concludes that regulators have a natural tendency towards some forbearance, but where authorities have an expanded mandate to explicitly oversee systemic risk they would tend to be even more forbearing towards systemically important institutions.

Similarly, some regulators that have access to information regarding a firm’s degree of systemic importance may have little incentive to gather and share it with other regulators. One conclusion of the findings is the more unified the regulatory arrangements that are implemented, the more the firm can reduce the degree of systemic risk for multiple regulatory arrangements. If nothing else, the conclusions highlight again the challenges of maintaining appropriate supervisory oversight of globally active, systemically important firms.

The EU has also focused on the issue, and specifically on the creation of resolution authorities. In January 2011 Internal Market and Services Directorate General (DG MARKT) published a working document which sought views on the technical details of a possible EU framework for the management of failing credit institutions.

As a matter of policy, the commission intends to take a series of steps towards a comprehensive EU-wide resolution and recovery framework for banks and other potentially systemic financial services institutions. As currently envisaged, the process towards the new regime will have three main phases:

— Adoption of a legislative proposal for a harmonised EU regime for crisis prevention and bank recovery and resolution. This will include a common set of resolution tools and reinforcement of cooperation between national authorities to improve the effectiveness of the arrangements for dealing with the failure of cross-border banks.

— The commission will examine the need for further harmonisation of bank insolvency regimes, with the aim of resolving and liquidating them under the same substantive and procedural rules, and will publish a report, accompanied if appropriate by a legislative proposal, by the end of 2012.

— The creation of an integrated resolution regime, possibly based on a single European Resolution Authority, by 2014. This final step would only be possible if a single set of substantive rules on resolution and insolvency had been implemented across the EU.

As they stand the proposals make it clear that European jurisdictions will be expected to set up “resolution authorities”, which will be separate and distinct from the supervisor, specifically to address the impact of possible regulatory forbearance as and when issues arise. The resolution authorities will be expected, in consultation with supervisors, to draw up and maintain resolution plans for each credit institution under their remit. The suggestion is that the resolution authority resolution plans could:

— Set out options for applying the resolution tools to the credit institution in a range of conceivable scenarios, including circumstances of systemic instability.

— Identify critical functions and the necessary support functions, the sudden withdrawal of which would cause wider financial instability, and set out options for ensuring their continuity on the failure of the credit institution.

— Identify preparatory measures, including the legal and economic separation of critical functions, which are necessary to facilitate timely and effective action to ensure their continuity on the failure of the credit institution.

— Identify and, where relevant, compile the information that will be necessary for the resolution authorities to apply the resolution tools and exercise the resolution powers to implement those options in a timely and effective manner if the credit institution meets the conditions for resolution.

— Identify how the resolution options would be financed. The plan should not assume extraordinary public financial support.


The UK intends to split up the regulator, but does not plan to create a separate resolution authority. This could increase the potential for regulatory forbearance in dealing with the next financial crisis. Set against this is the planned primacy of the financial stability objective for the proposed Prudential Regulation Authority (PRA) and the cooperation and information sharing plans between the PRA, the Financial Policy Committee (FPC) and the Financial Conduct Authority (FCA). In its country report no. 11/230: “United Kingdom: the future of regulation and supervision technical note”, dated July 2011, the IMF assessed the planned changes to the UK regulatory architecture, including the potential for regulatory forbearance.

The IMF stated: “Experience in other jurisdictions indicates that early intervention to deal with actual or potential material safety and soundness issues, before they cause irreparable harm, requires more than a prompt intervention regime, particularly for larger banks. It requires a mindset and culture of supervision and regulation.”

Echoing the sentiments of the governor of the Bank of England, the IMF noted that action will sometimes be required at a time when conditions appear to be robust but underlying risks are building up and some players are going beyond prudent behaviour — and will often strenuously resist intervention in their affairs.


A potential contributor to regulatory forbearance is the need to promote competitiveness in financial services. The IMF’s view is there is a strong argument that one of the reasons for regulatory failure leading up to the crisis was excessive concern for competitiveness. This lead to acceptance of the Financial Services Authority’s (FSA) “light touch” orthodoxy, which was further supported by the view that financial innovation should be encouraged at all costs.

Specifically, maintaining the need to “have regard” to competition would be seen as a material source of lack of clarity as to what the prudential regulator was supposed to do. It would also be unclear how the balance should be set in individual operational issues between the overarching objective and the obligation to “have regard”. This might hamper effective and speedy intervention.

The IMF has stated that it “strongly supports removing those from the legislation as now proposed”. It said: “An effective governance and consultation process, including inter-agency discussion as necessary, is an example of alternative ways of dealing with the legitimate concerns about how trade-offs will be made.”

Another example of the move away from regulatory forbearance is the FSA’s proposals on product intervention. Instead of waiting until a product is being sold to customers and then assessing whether or not it has the potential to cause significant harm, the FSA is seeking actively to avoid “large-scale episodes of customer detriment”. The FSA has defined product intervention as “regulatory interventions focused on products, including greater supervisory focus earlier in the value chain and of ongoing product governance, rules targeting product features, rules limiting sales of products and setting down specific conditions of sale”.

A range of radical approaches were suggested in discussion paper 11/1 with only express product pre-approval being subsequently ruled out. The potential to ban products or to ban or mandate product features, including setting minimum standards for products, are still up for consideration, as are price interventions, increasing the prudential requirements on providers, consumer and industry warnings, the prevention of non-advised sales and additional competence requirements for advisers.


Given the increased international and domestic focus on ensuring more supervisory intervention and less potential regulatory forbearance, where does that leave firms? One argument could be, for reasons of enlightened self-interest, that all firms would seek to work with their supervisor to ensure full information is shared leading to the best-quality judgment being made about any possible regulatory intervention. This optimistic scenario has a number of flaws, not least of which is the constant judgment of hindsight for any regulatory decision making.

Other issues include the presumption that senior managers have full, complete, up-to-date, meaningful and accurate information they are able to share with their supervisor, and that the supervisor is staffed with high quality, fully resourced employees who are capable and willing to make tough judgments, and are confident that their government will publicly support any action, or indeed inaction, they take.

In practical terms it is desirable for individual firms to be able to fail without either having a significant impact on the financial services marketplace or requiring a bail out from the taxpayer. A workable supervisory balance between regulatory forbearance and intervention will, however, be difficult to achieve in domestic marketplaces, and even more challenging when internationally systemically important firms are considered.

Firms need to ensure they continue to engage with their regulators and the domestic and international policy setters to manage expectations on resolution frameworks as well as information flows. No firm wants supervisory intervention, but excessive regulatory forbearance leading to the disorderly collapse of the firm would be even worse.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus.  Compliance Complete ( ions/regulatory-intelligence/compliance- complete/) provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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