Supervision and regulation
1 United Kingdom
1.1 The regulatory regime applying to the UK financial services industry
The Financial Services and Markets Act 2000 (“FSMA 2000”), containing an integrated legislative framework for regulating most of the UK financial services industry, came into force at the end of 2001. This and subsequent amendments established the Financial Services Authority (the “FSA”) as the single statutory regulator responsible for regulating deposit taking, insurance, mortgage and investment business in the UK.
Under the FSMA 2000, businesses require the FSA's permission to undertake specified types of activities including entering into and carrying out contracts of insurance; managing, dealing in or advising on, investments; mortgage business; accepting deposits; and issuing electronic money (‘regulated activities’). The FSA has published detailed regulatory requirements contained in a Handbook of Rules and Guidance.
The FSA’s statutory objectives are to maintain confidence in, and to promote public understanding of, the UK financial system; to secure an appropriate degree of consumer protection; and to reduce the scope for financial crime. In achieving these objectives, the FSA must take account of certain ‘principles of good regulation’ which include recognising the responsibilities of authorised firms’ own management, facilitating innovation and competition and acting proportionately in imposing burdens on the industry.
1.2 Authorised firms in the Group
As at 31 December 2006, 33 companies in the Group, spanning a range of financial services sectors (banking, insurance and investment business), are authorised to conduct activities regulated by the FSA. These companies are referred to as 'authorised firms'.
The FSA supervises the banking business of the UK based banks in the Group, including The Royal Bank of Scotland, NatWest, Coutts & Co, Ulster Bank Limited and Tesco Personal Finance Limited.
General insurance business is principally undertaken by companies in the RBS Insurance division, whilst life assurance business is undertaken by Royal Scottish Assurance plc and National Westminster Life Assurance Limited (with the Group’s partner, the AVIVA Group) and Direct Line Life Insurance Company Limited. Investment management business is principally undertaken by companies in the Retail Markets division, including Adam & Company Investment Management Limited and Coutts & Co Investment Management Limited, and in the Corporate Markets division, RBS Asset Management Limited.
1.3 The FSA’s regulatory approach and supervisory standards
The regulatory regime uses the full range of regulatory tools (including the authorisation of firms, rule-making, supervision, investigation and enforcement) available to the FSA. It is founded on a risk based, integrated approach to regulation.
The FSA can request information from and give directions to, authorised firms. It may also require authorised firms to provide independent reports prepared by experts. The FSA can exercise indirect control over the holding companies of authorised firms via its statutory powers to object to persons who are, or will become, ‘controllers’ of these firms.
As part of its regulatory approach the FSA carries out regular risk assessments of the Group which is also subject generally to direct and on-going FSA supervision.
The FSA carries out the prudential supervision and conduct of business regulation of all authorised firms and also regulates the conduct of their business in the UK. Currently, the application of its conduct of business rules to banking business is limited, but detailed conduct of business requirements apply to general insurance intermediary activities, mortgage business and investment business activities.
Prudential supervision includes monitoring the adequacy of a firm's management, its financial resources and internal systems and controls. Firms are required to submit regular returns to the FSA which provide material for supervisory assessment. Following the official adoption in the UK of the EU Capital Requirements Directive, new prudential sourcebooks were issued to take effect from 1 January 2007.
Many of the standards relating to the capital which firms must hold to absorb losses arising from risks to its business are determined by EU legislation or are negotiated internationally. The current capital adequacy regime requires firms to maintain certain levels of capital, of certain specified types (or tiers), against particular business risks.
In its supervisory role, the FSA sets requirements relating to matters such as consolidated supervision, capital adequacy, liquidity, large exposures, and the adequacy of accounting records and controls. Banks are required to set out their policy on ‘large exposures’ and to inform the FSA of this. The policy must be reviewed annually and any significant departures from policies must be discussed with the FSA. Large exposures must be monitored and controlled.
As regards the insurance industry, the FSA’s primary objective is to regulate and supervise the industry so that policyholders have confidence that they have bought appropriate products, and so that UK insurers are able to meet their liabilities and treat customers fairly. The FSA sets requirements relating to ‘margins of solvency’ (i.e. the excess of the value of assets over the amount of liabilities). Companies carrying out insurance business are required to submit regular returns covering reserves and solvency to the FSA.
Firms must also meet standards relating to senior management and internal controls and systems and must comply with rules designed to reduce the scope for firms to be used for money laundering. Revised Joint Money Laundering Steering Group Guidance Notes were published in February 2006 and came into force six months later. The EU has published its draft Third Money Laundering Directive which will supersede the two previous Anti Money Laundering Directives. Implementation is required by December 2007.
Conduct of business standards essentially govern key aspects of firms’ relationships with customers, and require the provision of clear and adequate information, the managing of conflicts of interest and the recommending of products suitable to the needs of customers. The marketing of financial products (particularly investment products) is subject to detailed requirements. The FSA is scheduled to issue new conduct of business rules during 2007 to comply with the implementation of the Markets in Financial Instruments Directive in November 2007.
1.4 Focus on customers
An important element in securing an appropriate degree of consumer protection is ensuring that suitable arrangements are made for dealing with customer complaints. Firms are required to establish appropriate internal complaint handling procedures and to report complaints statistics to the FSA. Where an issue cannot be resolved by the parties it may be referred for independent assessment to the Financial Ombudsman Service.
The FSA's high level principles require all regulated firms to treat their customers fairly. The FSA has undertaken a number of industry wide thematic reviews on this issue, and it has remained a primary supervisory theme throughout 2006. The FSA has indicated that it will include assessment of firms’ effectiveness in this area in regular risk assessments of firms.
The Financial Services Compensation Scheme (financed by levies on authorised firms) is available to provide compensation up to certain limits if a firm collapses owing money to investors, depositors or policyholders.
1.5 Fraud
During 2006, the FSA reviewed and reported on several fraud related topics across the financial services industry. These have been designed to raise awareness and understanding of their expectations in managing fraud risks at a general level such as ‘Firm’s High Level Management of Fraud Risk,’ and have also been issued to cover recommendations on specific topics such as ‘Online Fraud’, ‘Mortgage Fraud’ and ‘Commercial Property Fraud’.
1.6 Enforcement
Where appropriate, the FSA may discipline and/or prosecute for breaches of the legislative or regulatory requirements. The FSA works closely with the criminal authorities and uses both civil and criminal powers. It can withdraw a firm's authorisation, discipline firms and individuals, prosecute for various offences and require funds to be returned to customers.
The FSA also has powers under certain consumer legislation to take action against authorised firms to address unfair terms in financial services consumer contracts.
2 Europe
Much of the regulatory agenda in the UK and other European Member States in which the Group operates continues to be set by the European Union. Legislation comprising the EU’s Financial Services Action Plan is nearly complete and implemented, with attention now turning to the policy agenda through to 2010. The Commission wishes to pursue a different approach to policymaking: costed, evidence-based and targeted. Nonetheless, there are some major initiatives already in the pipeline; including a revised Consumer Credit Directive, a directive to establish a legal framework for the euro payments area, Solvency II (a revised EU capital framework for insurance companies), and possible legislation on mortgage credit and investment funds. The Group has been increasingly engaged with the EU and national policymakers on all these priority measures, and will aim to maintain this level of involvement.
The Group conducts business in several European countries. Notable European operations include business in the Republic of Ireland through the Ulster Bank (regulated by the Irish Financial Regulator); and Retail and Insurance business through the Retail Markets and RBS Insurance divisions in Germany, Italy, Spain and the Netherlands (regulated by those countries’ respective regulatory authorities). In all of these operations the Group recognises the importance of meeting the respective regulatory requirements.
3 United States
As the ultimate parent of Citizens’ subsidiary US banks, the company is a bank holding company within the meaning of, and subject to regulation and supervision under, the US Bank Holding Company Act of 1956, as amended (the ”BHCA”), by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”). Under current Federal Reserve Board policy, the company is expected to act as a source of financial strength to its US bank subsidiaries. Bank holding companies that meet certain eligibility criteria may elect to become ‘financial holding companies’ under the BHCA. The company elected to become a financial holding company effective in February 2004. As a financial holding company, the company may engage in any activity, and may acquire and retain the shares of any company engaged in any activity, that the Federal Reserve Board has determined to be ‘financial in nature’ or ‘incidental’ or ‘complementary’ thereto. Activities that meet these criteria include unrestricted securities underwriting and dealing, insurance underwriting, and various venture capital or investment activities. Financial holding companies must give the Federal Reserve Board after-the-fact notice of any such new activities.
Bank holding companies (including bank holding companies that are also financial holding companies, such as the company) are required to obtain the prior approval of the Federal Reserve Board before acquiring, directly or indirectly, the ownership or control of more than 5% of any class of the voting shares of any US bank or bank holding company.
The company’s US bank and non-bank subsidiaries and The Royal Bank of Scotland’s US offices, are subject to direct supervision and regulation by various other federal and state authorities. Citizens’ state-chartered bank subsidiaries are subject to regulation and supervision by state banking authorities and the US Federal Deposit Insurance Corporation, and The Royal Bank of Scotland’s New York branch is supervised by the New York State Banking Department. The company’s US insurance agencies are regulated by state insurance authorities. The company’s US securities affiliates, including Greenwich Capital Markets, Inc., are subject to regulation and supervision by the US Securities and Exchange Commission and various self-regulating organisations. The futures activities of Greenwich Capital Markets, Inc. are also subject to oversight by the US Commodity Futures Trading Commission and the Chicago Board of Trade. Charter One Bank, N.A., Citizens Bank, N.A., and RBS National Bank are regulated and supervised primarily by the US Office of the Comptroller of the Currency.
On 26 October 2001, the President of the United States signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001 (the “Patriot Act”). The Patriot Act was renewed on 2 March 2006 and signed into law by the President of the United States on 9 March 2006. The Patriot Act significantly expanded the responsibilities of financial institutions in preventing the use of the US financial system to fund terrorist activities. Title III of the Patriot Act (officially, the “International Money Laundering Abatement and Anti-Terrorist Financing Act of 2001”) is the anti-money laundering portion of the Patriot Act. Title III provided for a sweeping overhaul of the US anti-money laundering regime. Among other provisions, it requires financial institutions operating in the United States to (i) give special attention to correspondent and payable-through bank accounts, (ii) implement enhanced reporting, due diligence and “know your customer” standards for private banking and correspondent banking relationships, (iii) scrutinise the beneficial ownership and activity of certain non-US and private banking customers and (iv) develop new anti-money laundering programmes, due diligence policies and controls to ensure the detection and reporting of money laundering. The Patriot Act requires all US financial institutions to develop anti-money laundering programmes. Such required compliance programmes are intended to supplement any existing compliance programmes for purposes of requirements under the Bank Secrecy Act and the Office of Foreign Assets Control Regulations.
4 Other jurisdictions
Through its Corporate Markets and Wealth Management divisions, the Group conducts business in various other jurisdictions and is regulated by many financial and other regulatory bodies around the world. These jurisdictions include among others China, Hong Kong, Japan, Singapore and Australia in the Asia Pacific region; Abu Dhabi, Dubai and Bahrain where the Group has branches and representative offices; and Switzerland and the Channel Islands.
5 Regulatory developments for capital and risk management
The Basel Committee on Banking Supervision issued new requirements for firms’ risk weighted asset (“RWA”) calculations in June 2004. These rules are generally referred to as Basel 2.
In the EU, this new framework became law through the Capital Requirements Directive and associated changes to national laws or regulatory guidelines (e.g. the FSA’s GENPRU and BIPRU). Within the US, regulators have the flexibility to implement Basel 2 directly, after their final Notice of Proposed Rulemaking. Full adoption of these rules comes into force across the EU on 1 January 2008 and the US from 1 January 2009.
Application of Basel 2 differs between jurisdictions. The EU is applying Basel 2 to all banks and investment firms. The US is taking a different approach, mandating that the largest internationally active US banks use the ‘Advanced’ approaches for credit and operational risk calculations; other US banks will remain on the pre-existing standards or a modified version thereof (Basel 1 or Basel 1a) or decide to ‘opt-into’ Basel 2. Our US subsidiary, Citizens Financial Group, is an ‘opt-in’ firm for these purposes.
The Group has submitted a request to the FSA (generally referred to as a ‘waiver’) to adopt the Advanced Internal Ratings-Based approach (“AIRB”) for the majority of the Group’s EU credit risk exposures from the earliest possible date, January 2008. In order to satisfy the requirements for AIRB, which is the most sophisticated option available to firms, banks are required to have risk grading, scoring and validation approaches that calculate the Probability of Default, Exposure at Default and Loss Given Default for each facility. Outputs from these models, along with other factors, such as maturity, are then used to calculate RWAs according to regulatory formulas.
The implications of the new rules are becoming clearer. Assuming average risk profiles, banks will require less capital to support lending to residential mortgages and other retail and small and medium enterprises. Good quality corporate lending should also see a reduction in capital requirements. Conversely banks, on average, will be required to hold more regulatory capital for some specialised lending and equity exposures, sovereigns and poorer quality bank and corporate credits, although the actual capital requirements under Basel 2 depend on a number of factors, including collateral.
Basel 2 introduces, for the first time, an explicit requirement to hold capital for operational risk. Of the available options, the Group is adopting ‘The Standardised Approach’ initially, with the objective of migrating to the more sophisticated ‘Advanced Measurement Approach’, in line with the US implementation. In addition, Basel 2 also introduces two new elements – a formal supervisory review process (Pillar 2) and more extensive market disclosures (Pillar 3). The Group is making good progress in both areas, in advance of formal implementation in 2008.
© 2007