The FSA is to be broken up as part of a huge shake-up of regulation by the new Government – despite strong misgivings from City professionals. Alex Aldridge charts the watchdog's rise and fall and looks at the new bodies that will replace it

'You got a lotta nerve,' begins the mural in the reception area of the Financial Services Authority's (FSA's) Canary Wharf headquarters. The words are part of a 1998 canvas by Turner Prize-nominated artist Fiona Banner, spelling out the lyrics of Bob Dylan's song, Positively 4th Street.

It is a strange choice of artwork for the main slot in the lobby of the UK's financial regulator. Even during the 'anything goes' boom years of the mid-part of the decade it must have looked somewhat out of place. And now it just seems an uncomfortable reminder of the excessive nerve – and boundless appetite for risk – that the FSA failed to curb.

A plaque below the picture explains its significance to the City watchdog. "The work is striking, startling, slightly unsettling and amusing. It acknowledges a different edge to the organisation. It reflects an ethos of boldness, wit and curiosity." As it turned out, it was a perceived lack of these qualities – alongside a concern that the current system of regulation failed to adequately recognise the huge build-up of debt and risk in the markets – that saw the new coalition Government announce last month the abolition of the tripartite system of regulation of which the FSA was the central element.

"The very design of the policy framework meant that responding to an explosion in balance sheets, asset prices and macro imbalances was impossible," Chancellor George Osborne told City luminaries in the annual Mansion House speech, which confirmed the axe would fall on the FSA, which employs 3,300 staff, among them around 250 practising lawyers. "The Bank of England was mandated to focus on consumer price inflation to the exclusion of other things," continued Osborne. "The Treasury saw its financial policy division drift into a backwater. The FSA became a narrow regulator… and when the crunch came, no-one knew who was in charge."

Things could only get better…

Created immediately in the wake of Labour's 1997 election victory, the FSA was, along with the handing of independence on monetary policy to the Bank of England, the most famous policy of incoming Labour Chancellor Gordon Brown, then at the height of his political power following the Labour Party's landslide victory.

The FSA replaced nine mainly self-regulatory bodies that covered deposit-taking, insurance and investment businesses. The move to end self-regulation for the financial services industry and consolidate oversight responsibilities following a series of financial scandals in the 1990s, culminating in the collapse of Barings Bank in 1995, was broadly welcomed.

Barclays group general counsel Mark Harding recalls the pre-97 regulation regime as "not really being fit for the modern world". He continues: "Back then bank regulation was still very much subject to the Bank of England's discretion and the regulatory system was very fragmented. So the creation of the FSA was widely perceived to be a good thing."

Yet there was a contradiction at the heart of the new regulator. On one level the FSA was partially modelled on the US's influential Securities and Exchange Commission and was designed to usher in a more prescriptive mode of policing the City. And, to a certain extent, the FSA did bring in a more rigorous, or at least formalistic, style of regulation.

On the other hand the prevailing intellectual thrust of the day was one which strongly favoured deregulation in banking, financial services and capital markets. This school of thought had grown out of an academic movement in the US during the 1970s and quickly became influential in shaping policy in the US administration of Ronald Reagan and in the UK under Conservative Prime Minister Margaret Thatcher.

In the narrow context of financial services, this shift was illustrated in the 1980s with the US Garn-St. Germain Depository Act, which relaxed the rules surrounding savings and loans associations and allowed banks to provide adjustable rate mortgage loans. And it arguably reached its zenith in 1999 with the Gramm-Leach-Bliley Act, which repealed part of the 1933 Glass-Steagall Act, the legislation ushered in as a response to the crash of 1929 to deal with the failures and excesses of the US finance industry. The core of Glass-Steagall, which prevented institutions acting as a combination of investment banks, commercial banks and insurance companies, was increasingly being abandoned as powerful financial 'supermarkets' like Citigroup and JP Morgan sought global scale and domination across multiple product lines.

In the UK the movement was most obviously manifested in the 1986 'Big Bang', the huge deregulation of financial services which saw the abolition of fixed commission charges and the distinction between stockjobbers and stockbrokers, plus a switch from open outcry to electronic trading. The effect of the changes was to open up the London Stock Exchange (LSE) – previously something of a closed shop – accelerating the internationalisation of the City, which quickly emerged as a financial centre to rival New York.

Business-friendly, light-touch and focused on principles rather than rules, the FSA reflected the optimistic mood of the New Labour era. According to FSA general counsel Andrew Whittaker, who was with the organisation from the start, joining from its main predecessor body, the Securities and Investments Board, there was "a sense of the City growing to take advantage of further opportunities". He continues: "As we built the FSA, at the time we were focused on building something that would endure. Although, of course, we knew too that we existed at the will of Parliament." As the glossy new watchdog of one of the world's leading financial centres during a time of robust economic growth, the FSA came to be seen as a leader among regulators worldwide. "At the peak of its powers the FSA strutted the world stage, championing the City's interests, leading international thinking on regulatory matters and drawing plenty of admiring glances," remembers Denton Wilde Sapte financial markets and regulation head Robert Finney.

But there was discomfort among some about the watchdog's overly close relationship with the City – a chumminess that would lead Private Eye magazine to nickname the organisation the 'Fundamentally Supine Authority'. Hugo Oppelaar, a partner at Dutch law firm Houthoff Buruma, recalls the sometimes breathless enthusiasm shown by the FSA towards championing the City. "They were very keen on the City, sometimes a bit too keen and overly ready to accommodate the industry. Indeed, the strength with which the FSA promoted the UK's interests represented something of a conflict of interest. You see regulators in Luxembourg or Jersey doing that sort of thing, but not a regulator from a major country."

This mentality is ascribed in part to the presence of many ex-bankers among the FSA's senior ranks. On reflection, their relaxed approach to risk seems to have permeated the organisation. In 2003, for example, the Treasury Select Committee accused the organisation's then chief executive John Tiner (formerly a managing partner with Arthur Andersen) and chairman Callum McCarthy (an ex-Barclays and Dresdner Kleinwort banker) of propagating the City's old boys' network in the way they ran the organisation, demanding to know why Lloyds TSB was fined only £1.9m for selling so-called precipice bonds to thousands of customers. (By way of comparison, in the same year the Office of Fair Trading (OFT) fined Argos £17.3m for fixing the price of toys).

There was also a feeling that, while the FSA's culture remained a good deal more austere than that prevailing in the investment banks, some of the City's excesses were spilling over into the watchdog – as evidenced by the £12,100 spent on the leaving party of Tiner, a man who drove a Porsche with the personalised number-plate T1NER during his tenure as FSA chief executive.

But more serious was evidence that the FSA in some cases simply lacked the skills and determination to properly police the City. As part of the watchdog's 2008 review of its dealings with Northern Rock, which the Government was forced to nationalise after the onset of the credit crunch, the regulator's internal auditors uncovered, among other things, that for 12 months the stricken bank was monitored by supervisors with expertise in insurance rather than banking and that details of the worsening risks presented by the bank were not entered into the FSA's database. More generally, criticism has emerged of the organisation's rather slavish adherence to the principles-based system of regulation it so vocally advocated.

One of the effects of this was that it placed too much power in the hands of fairly junior staff. "The problem with the principles-based approach is that, by its lack of focus on specific rules, it can mean regular line staff end up with high levels of discretion to make some often quite important decisions. That certainly happened at the FSA," comments Barney Reynolds, head of the global financial institutions advisory and financial regulatory group at Shearman & Sterling.

Crunch time

As the FSA established itself in booming markets the trends that would lead to the credit crunch – which began in 2007, and led to an international banking crisis the following year – were having a huge, if little noticed, impact on markets.

Moves by central banks to slash interest rates after the terrorist attacks of 11 September 2001 while the dotcom boom was already turning to bust flooded global markets with cheap money. This contributed to a dramatic build-up in personal and mortgage debt by consumers in Western economies.

Innovation in financial products by investment banks made a risky situation substantially more dangerous. One consequence of the explosion in asset-backed debt securities was that lenders could easily sell on their commitments to investors. By common consent, this contributed to a major deterioration in lending standards – a trend that would be most obviously apparent in the US 'sub-prime' mortgage market; in essence, thousands of people had been lent money that they had no hope of paying back. Other related factors exacerbated the situation still further. 'Slice and dice' credit derivatives, like collateralised debt obligations, were thought to more effectively price and distribute risk to investors looking for higher returns. In reality, once the market seized up, the products were impossible to price, impossible to move and far riskier than their credit rating suggested.

Another crucial factor was that financial institutions were more interconnected than ever due to the growth in credit derivatives and an increasing reliance on short-term interbank lending. That meant that when problems – or even merely a perception of problems – started impacting on some institutions, market tremors could instantly be transmitted through the system.

Yet underneath the huge complexities of cutting-edge financial products, the credit crunch and banking turmoil resembled most banking crises: banks operating with too much borrowed money, lent too much to too many people and businesses that could only service the debt if the economy kept growing.

Of course, few market regulators in the world proved adept at identifying or countering such a systemic build up of market risk. But some of the FSA's critics argued this exposed the flaw in the tripartite system that Brown had created in that it divided so-called macro-prudential supervision from the policing of individual institutions, creating gaps between the FSA, the Bank of England and the Treasury.

Indeed, monitoring this market risk was not in the FSA's remit. But it was still an embarrassment that the body responsible for overseeing prudential risk at micro level in arguably the most important financial centre in the world failed so completely to see the coming market collapse. On 12 June 2007 news of a crisis erupting at a hedge fund with close ties to US investment bank Bear Stearns broke. From that point, the world's love of light-touch regulation began to fade very quickly as accusatory fingers began suddenly to point in the direction of the FSA and its counterparts worldwide.

A question of mindset

While there is no doubt the FSA made some huge mistakes, the collective failure of regulators around the world lead many to attribute the financial crisis primarily to mindset. In her book, Fool's Gold, The Financial Times (FT) journalist Gillian Tett assesses the boom years from an anthropological perspective, arguing that in most societies elites attempt to hold onto power not just through the accumulation of wealth but by ideological domination – in other words, deciding what is talked about and what is not. The result in this instance, Tett says, was a "social silence" around the explosion of complex financial instruments and the power of the banking sector that applied to everyone – including the regulators.

Philip Augar, a former investment banker with NatWest and J Henry Schroder and author of several books on the City, including The Death of Gentlemanly Capitalism and Chasing Alpha, sees things similarly: "The deep-seated global trends advocating deregulation and freedom of markets prevailing at the time were, let's not forget, extremely powerful. In that context it seems disingenuous to blame regulators for everything."

Meanwhile, Peter Kurer, former chairman of Swiss banking group UBS, recalls "almost nobody looking at the big picture – not the politicians, not the bankers, not the journalists, not the regulators." He adds: "There were a small number of guys like [economist] Nouriel Roubini and [FT columnist] Martin Wolf issuing warnings, of course, but people weren't listening to them."

The situation faced by the FSA is illustrated by an incident at the height of the market in 2005 when then Prime Minister Tony Blair delivered a speech describing the regulator as "seen as hugely inhibiting of efficient business". Although the then FSA chairman Callum McCarthy reacted robustly, formally requesting Tony Blair explain his remarks or retract them, the Prime Minister's response was never made public – the failure to resolve the matter giving an indication of the political pressures the City watchdog was under to reflect the established view that the good times were here to stay, and to regulate accordingly.

Now that the mood has changed, the overwhelming consensus – particularly strong among regulatory lawyers – is that the FSA has upped its game significantly.

"I don't think structure was the cause of the problem," argues Barclays' Harding (pictured). "This is backed up by how impressively the FSA has responded since the crisis, demonstrating that it is capable of doing a good job under the tripartite system. It is rather ironic that it is being broken up at the time when it's performing better than it ever has." This improvement is manifested principally in a more proactive and careful approach, say lawyers. "The FSA is now much more hands-on and our daily dealings with them have certainly increased hugely," adds Harding.

"Previously, the FSA was quite responsive to industry pressure," comments Dentons' Finney. "Now it's much harder to push applications through for new authorisations and changes to existing permissions." This new philosophy was reflected this year in the FSA's handling of Prudential's attempted takeover of AIG's Asian life insurance business, which saw the watchdog force Prudential to delay the launch of its $21bn (£14bn) rights issue after it failed to convince the regulator that it would have enough capital after the takeover. "This clearly showed, after Northern Rock and ABN AMRO, that the FSA has completely changed the way it supervises banks," remarks Nabarro head of financial services regulation Rob Moulton.

Recent months have also seen the FSA announce tougher liquidity rules, new guidelines on remuneration to encourage proportionate risk-taking and a harsher regime for handing out fines for rule breaches.

A harder-line stance has also been taken on enforcement. "The FSA has become far more aggressive when it comes to enforcement over the last few years," says Carlos Conceicao, a litigation partner at Clifford Chance (CC) and formerly head of the FSA wholesale group in enforcement. Previously seen as a last resort, enforcement has soared up the agenda since the financial crisis – with total fines brought in last year standing at £35m, up from £22.7m in 2008. Last month the body handed out by far its largest-ever fine, a £33.32m penalty against JP Morgan, for failing to adequately protect client money.

And despite experiencing a setback on 3 June when 'not guilty' verdicts were recorded against three men – including two former City lawyers – in an insider trading case, the FSA has won plaudits from the legal profession for taking on and winning a string of high-stakes criminal prosecutions for market abuse over the last 18 months.

Recent scalps include David Baker, the former deputy chief executive of Northern Rock, who was fined £504,000 in April for making misleading statements to the market, and Malcolm Calvert, a former Cazenove stockbroker, who is now serving 21 months in prison for insider dealing.

Much of this success has been built on a US-style 'revolving door' policy encouraged by enforcement chief Margaret Cole where lawyers and bankers are recruited from private practice, typically giving three to five years of service, before moving back into the private sector (Cole herself was a partner at White & Case before joining the regulator). Although this policy has been ongoing for a while, it has gained momentum since the onset of the economic crisis as redundancies at many City institutions – and the heightened profile of regulatory enforcement – have enabled the FSA to secure some top-level talent that a few years back would have been out of its league. "There is no doubt the financial crisis has boosted the FSA's capacity to attract quality people," says UBS global head of compliance Andrew Williams, while another senior banker comments: "When the public mood is in favour of greater regulatory scrutiny it makes the watchdog's job easier at all levels."

The mood in the camp

Under the changes announced by Osborne last month, the micro-prudential regulation previously carried out by the FSA will be transferred to a subsidiary of the Bank of England, to be known as the Prudential Regulation Authority charged with day-to-day supervision of financial institutions. Meanwhile, the Bank's nominal macro-prudential role in policing market risk will be beefed up and housed within a newly-created Financial Policy Committee.

The remaining markets and consumer divisions of the FSA will operate as part of a new Consumer Protection and Markets Authority (CPMA), which may also include some elements of the organisation's enforcement function. This body will act as a single conduct regulator for both retail and wholesale firms. The rest of enforcement is seen as likely to merge with bodies including the Serious Fraud Office (SFO), the Serious Organised Crime Agency (SOCA) and parts of the OFT to form a new Economic Crime Agency (ECA). This is characterised as a 'twin peaks' model separating 'prudential regulation' – essentially the imposition of standards requiring institutions to control risk and hold enough capital to protect deposits and avoid market meltdowns – from conduct regulation – the policing of suspected rule breaches by individual institutions. Prudential regulation, both at a market level and day-to-day supervision of institutions, will reside with the Bank of England.

The aim is to complete the transition by 2012, with an interim shadow structure set to be brought in at the FSA by January next year. Current chief executive Hector Sants is to stay on to oversee the changes – despite coming out against the proposals when they were announced by the Conservative Party while in opposition.

With details of the new structure still thin on the ground, the dominant feeling within the FSA – which boasts an annual budget in excess of £450m – is uncertainty, say insiders. "At the moment nobody really knows what is happening," one FSA lawyer comments, adding: "Normally after we do a risk assessment we send a letter saying we'll be back in two years. But that's obviously not going to be the case now. So at the moment we're just not sending the letter."

Still, even with the current lack of details, a few distinct concerns have emerged. The first involves divisions likely to be split up under the new arrangement – such as the general counsel group headed up by Whittaker, which contains 70 lawyers – with many staff set to lose some of their responsibilities. "There are some senior people at the FSA who I don't see taking kindly to having their roles effectively downgraded," says one private practice lawyer. For those at the top the situation is worse, with some senior management roles set to disappear altogether. The departure last month of the organisation's head of supervisory, John Pain, is believed to have been related to concerns about where he would have fitted into a new structure.

Well-regarded head of risk Sally Dewar also left in June, before the plan to split up the FSA had been announced. Meanwhile, there have also been a host of departures at more junior level. "I'm at a leaving drinks every week at the moment," said one FSA staff member. "It started at the top with Dewar and Pain, but it's trickling through." However, with a Treasury paper on the changes, due to be published at the end of this month, set to provide some keenly awaited extra information, recruiters specialising in this area are reporting "no flood of calls". James Limburn of Gibson Limburn Search comments: "Most FSA people I've spoken with are still very much in 'wait and see' mode."

Looking ahead, FSA staff suggest decisions to stay or go may come down to which of the two main factions prevailing within the body that individuals belong to. The first group is made up of those who moved across from the predecessor regulatory agencies when the FSA was created in 1997. Having seen upheaval before, these 'lifers' are apparently fairly relaxed about the changes, particularly as some of them originally worked at the Bank of England.

The second group – comprised of people who have joined the FSA over the last few years from private sector City jobs – are much more likely to move. Already disgruntled by the FSA's January pay freeze and having seen the worth of their CVs rise as law firms and banks seek to staff up in response to the many regulatory changes taking place right now at European and international level, these staff will be hard to retain. Some argue that a tipping point may soon be reached where there is an exodus of people from this camp.

While here is a degree of kudos associated with working at Threadneedle Street – "The Bank is seen as a very prestigious place to work. A subsidiary of the Bank of England would probably acquire some of its sheen," says Shearman's Reynolds – the newly-created CPMA is unlikely to hold particular allure. The reason for this is that the FSA consumer protection division and markets group are widely regarded to be a poor match.

"There's no real reason to have these two groups in the same place because they do such different things. Putting them together seems like an afterthought," says Nabarro's Moulton. Indeed, the original Conservative white paper published last year laying out plans for a new regulatory structure featured a separate consumer protection agency, with no mention of a markets division at all – an implicit recognition that market supervision does not fit neatly into the so-called 'twin peaks' model of regulation on which the Government's plans are based.

Some believe the decision to put markets with consumer protection was driven by a motivation to dilute the traditionally more 'left-wing' identity of the latter. "The logic of combining them may come down to balancing the political influence of the consumer division, which would have the potential to grow increasingly anti-City if left to operate on its own," says Norton Rose partner Jonathan Herbst, a former head of European law at the FSA and the only lawyer on the Conservative committee put together to discuss the FSA overhaul while the party was still in opposition. Others see the new CPMA as a first step towards splitting off the FSA's consumer division and perhaps moving it out of London altogether.

"In five years time I wouldn't be surprised to see a separate consumer protection agency working out of, say, Manchester or Newcastle. As a division it's not something that needs to have close links to the City; in fact, to police it effectively on the consumer side, it needs some distance," argues Moulton. Either way, the immediate result of bringing the two together is, according to one member of the markets division, "that people here are not particularly pleased".

Worse than getting lumped in with the consumer group, though, is the prospect of being transferred to the new ECA – a likely outcome for at least some parts of the current FSA enforcement division, which as a whole is home to around 170 of the FSA's lawyers. Unlike the CPMA, which is expected to be funded by a levy from the companies which it regulates in a similar manner to the FSA, the ECA will be directly funded from the public purse. The result? The ECA will probably be unable to match the salaries of current FSA staff members (which are around 30%-40% higher than those paid by the state-funded SFO).

With the enforcement division's recent successes built at least in part on an ability to attract experienced people – including stars like Cole and in-house barrister Sarah Clarke (formerly of 187 Fleet Street Chambers) – thanks to its capacity to pay attractive salaries, the changes represent a real threat.

At this stage, however, nobody knows what will happen. Some predict enforcement will all go to the ECA; others expect the enforcement team to move in its entirety with the markets division to the CPMA. That certainly seems to be what Cole is hoping for, having told the FSA enforcement conference last month that it is "vital that the momentum of enforcement activity is kept up during the transition to the CPMA". As the lobbying in favour of each option hots up, probably more likely is some sort of compromise, say lawyers, with criminal enforcement potentially going to the ECA and civil to the CPMA. Another mooted possibility is insider trading – an area which requires heavy resources – being ring-fenced within the CPMA while everything else is transferred to the ECA.

Shuffling the deckchairs

While the FSA inspires passionate allegiance among few, the consensus among City advisers is that scrapping it will not make the UK's regulatory framework better and could make it worse. Certainly, there is a clear feeling among financial services lawyers that it was the style and rigour of regulation that fell short ahead of the credit crunch rather than the tripartite regulatory architecture.

"Substantive regulation is far more important than the frameworks which enforce it ," argues Sullivan & Cromwell senior chairman Rodgin Cohen (pictured), regarded by many as the US's leading authority on bank regulation. "If you look around the world there is no correlation between regulatory structure and where the crisis struck most severely."

Many see the shake-up as an ideologically-driven assault on a signature policy of Gordon Brown. "The announcement does have a shuffling-of-deckchairs feeling to it. It might not have all that much impact on most financial services firms, which may not even notice a change," says CC partner Simon Gleeson.

With a few significant tweaks, say lawyers, the current UK structure could have been modified to sufficiently remedy the disconnect between the regulation of markets and individual institutions. "Mechanisms could have been created within the existing system for the Bank of England to receive all the necessary information arising from the micro-prudential supervision of banks (and other financial institutions) and still be in a position to be accountable for macro-prudential actions," argues Finney.

Kurer cites the Swiss regulatory system – where the two regulators, the Federal Office of Private Insurance and the Swiss Federal Banking Commission were merged, but not completely re-ordered, at the onset of the credit crunch to form the Swiss Financial Markets Authority – as an example the UK could have followed. "By bringing the FSA and the Bank of England together at the top with a few guys coming together to speak a lot more, rather than overhauling the whole system, you could have created a similar effect," he says.

Meanwhile, it is widely assumed that the huge upheaval will come with a host of teething problems. "Whenever you split functions, you clearly get a greater prospect of overlap, and perhaps even more concerning is issues falling between gaps," says CC's Conceicao. And many question the record of the 'twin peaks' regulatory model. A recent report from the Scheltema Commission in The Netherlands – which operates the twin peaks model of regulation – raised concerns about the uneasy relationship between the country's prudential and markets/consumer regulators following the collapse of Dutch bank DSB last year. "There are very different cultures that prevail in the prudential regulator and our markets and consumer body," says Houthoff Buruma's Oppelaar. "At the end of the day, twin peaks isn't perfect; if it was, it would be used in every jurisdiction." Anxiety has also been expressed about the effect of the upheaval on a market already working flat out to adapt to the raft of regulatory changes of the last few years – and bracing itself for the result of ongoing negotiations over Basel III international banking standards and impending changes to financial services regulation in the European Union and the US. "The timing will add to the burden on firms given the tsunami of other reforms they are dealing with," says Freshfields Bruckhaus Deringer financial services group head Michael Raffan.

Lawyers agree that ultimately it is these developments at an international level – which focus on proposals to force banks to hold more capital and liquid assets and will likely see an amendment made to the European Capital Requirements Directive – that will determine the City's success or otherwise in avoiding another system-threatening financial crisis.

Raffan (pictured) continues: "Many of the areas of substance in the ongoing reforms of the way banks and financial services companies are regulated will be settled internationally, rather than by individual national regulators." The FSA, then, is left, amid the grand claims expressed in that Mansion House speech, as more than anything else a victim of one Government's enthusiasm to create a symbolic break from its predecessor. "You say I let you down. You know it's not like that," continue the Dylan lyrics in the mural up there on the wall in the FSA's lobby.

Those at the soon-to-be-defunct watchdog know the feeling.

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Key financial regulation briefings from Legal Week Law

- Corporate newsflash – FSA to be abolished, Ashurst
- Understanding the new Dodd-Frank financial reform legislation, Mayer Brown
- Client assets and client money – sit up and take notice, Herbert Smith
- SFO plea bargains in corruption cases – the Court of Appeal's view, Allen & Overy
- Goldman SEC charges could spark litigation frenzy, Eversheds
- Implementing the Financial Services Act 2010: Short selling, Travers Smith
- FSA's corporate governance framework and intensive supervisory approach, Herbert Smith
- Avoiding corruption risk in the City, Norton Rose
- FSA Business Plan 2010/11 – An Overview, Denton Wilde Sapte
- SEC Cooperation Initiatives: New Risks for Public Companies, Latham & Watkins
- SEC proposes massive ABS rule changes, Mayer Brown
- Private equity comment – the Alternative Investment Fund Managers Directive, SJ Berwin
- Regulatory urban myths – a financial services and markets update, Travers Smith
- Bureaucrats at the gate, Baker & McKenzie

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Feeling that white collar – the birth of the Economic Crime Agency

The lease on the Serious Fraud Office's (SFO) Holborn headquarters expires in 2012 – good timing, as it turns out, with the Government's shake-up of the financial regulatory structure set to see the organisation disbanded in two years' time in favour of a new Economic Crime Agency (ECA).

The details remain unfinalised, but at this stage it looks like the ECA will be made up of the SFO, the City of London Police Economic Crime Directorate, the Crown Prosecution Service fraud unit, the Serious Organised Crime Agency (SOCA), parts of the Office of Fair Trading's (OFT) enforcement team and elements of the Financial Services Authority's (FSA) enforcement function. The aim is to improve the UK's much-derided ability to successfully prosecute serious financial crime.

The SFO, which with its 300 staff (of which 60 are lawyers) will be the largest element of the new organisation, is in favour of the move. "Obviously the new structure is something for ministers to decide, but the changes would certainly simplify things," says Richard Alderman (pictured), the director of the SFO. "Under the present arrangement there is some confusion about who to go to. The City of London police? The FSA? The SFO? And it's true that sometimes there is overlap – particularly between us and the FSA enforcement division."

SFO lawyers talk of "constantly liaising" with their peers at the FSA and the OFT under the current set-up, suggesting that it would be more convenient for them all "to be under one roof". However, they express concern about the unsettling effect of the changes in the short term. "Already there have been a few people leave in response to the announcement, and I could see it being a catalyst for more departures," one SFO case manager told Legal Week. The problem facing the organisation, which is subject to the civil service hiring freeze in place until April next year, is how it replaces these people. "There is the possibility of bringing people in from elsewhere in the Government Legal Service, but they are not always a good fit," says the case worker.

Unlike the SFO, the OFT and the FSA enforcement divisions are less happy about the prospect of joining the ECA, with both currently lobbying to retain their criminal enforcement powers (which in the FSA's case would see it move to the newly-created Consumer Protection and Markets Authority (CPMA) under the new arrangement). The OFT's recent less-than-spectacular track record – in May its price-fixing prosecution against Virgin Atlantic and British Airways collapsed weeks after the trial commenced – means its bargaining position is seen as weak. The FSA's criminal enforcement function, on the other hand, looks like it has a real shot at resisting attempts to move it into the ECA. This is a result of a string of recent high-profile victories and an atypical funding model, which sees it financed by a levy from the companies it regulates. As a result, the FSA can pay salaries 30%-40% higher than the state-funded SFO. The ECA looks likely to be entirely publicly funded – and as such unable to match FSA pay. Lower salaries, argues FSA enforcement head Margaret Cole, would mean losing many of the leading lawyers and other professionals who have joined from the private sector in recent years and are strongly associated with the division's recent successes.

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Taming banks – the international effort

The future of the financial services industry will be governed, more than anything else, by the negotiations over regulatory reform that are currently ongoing across the globe. Perhaps the most important of these are the discussions being conducted by the Basel Committee on Banking Supervision, which is considering reforms to force banks to hold larger amounts of capital and create global liquidity standards. It aims to implement the former by November, in time for the G20 meeting in Seoul. While banks are concerned that the new rules could hit their profitability, they are keen for as much international harmonisation as possible in the way they are regulated. "The large banks are truly international, so regulation needs to be decided as much as possible at G20 level," says UBS global head of compliance Andrew Williams.

The reforms taking place in the US – via the Dodd-Frank Bill – will also have global significance. The Bill, which was approved last week by the US Senate, will usher in a number of substantive reforms. These include more stringent capital, leverage and liquidity standards for institutions deemed to be systemically significant; the creation of a new Consumer Financial Protection Bureau to tackle abusive selling of retail products like mortgages and credit cards; and a new resolution process for the liquidation of systemically important institutions. The Bill also includes the so-called 'Volcker Rule', which will restrict banks from making certain kinds of speculative investments on their own account. Under the rule deposit-taking banks will be banned from proprietary trading and see restrictions imposed as to what they can invest in private equity and hedge funds. It will also even out the level of liabilities they can hold – meaning they will be forced to spin off around a third of their derivatives activities to subsidiaries. "The Dodd-Frank Bill has substantial teeth," says Sullivan & Cromwell senior chairman Rodgin Cohen. "The resolution process, for example, looks like it should provide the opportunity to deal with the failure of a major financial institution in a way that prevents a falling domino effect among the financial community."

In Europe, plans are afoot to create European Union-wide macro and micro prudential supervisory bodies. Consultations are also ongoing at European Commission level over new rules to police derivatives and short selling. And tough new standards governing the regulation of hedge funds and private equity funds, under the controversial Alternative Investment Fund Managers Directive, look set to be finalised before the end of the year.

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Breaking up the banks?

The scrapping of the FSA dominated the headlines following Chancellor George Osborne's speech at Mansion House last month, but the new Government-appointed Commission on Banking – announced during the speech – could have a greater long-term impact on the City.

The Commission, which met for the first time on 9 July and will issue a final report in September next year, has a brief to consider how the UK's banking sector can be made safer and more consumer-friendly. The key question confronting it is whether or not to bring in a split between retail and investment banking in the style of the 1933 US Glass-Steagall Act, which was introduced as a response to the stock market crash of 1929. The consensus among lawyers is that such a radical move is improbable given that neither the European Union nor the US appears likely to bring in equivalent legislation. "For the UK to go it alone on this would be extremely risky, as banks could just go somewhere else not necessarily far away, like Paris. Of course, a global move in this direction may be a different matter," says Norton Rose partner Jonathan Herbst (pictured). "And in any case, you could achieve the same results through, for example, making a change to insolvency law which would force the separate pooling of assets and liabilities."

A more likely alternative is for the Commission to recommend moves to increase competition in the sector, either through tougher antitrust policies or to encourage new entrants.

However, some believe the UK Government could be prepared to plough its own path and push for some form of separation between different types of financial institutions. "Don't forget the structure of the UK banking industry is different to that in other countries, so while the Government will clearly have regard for what is happening in the US and Europe, it's not inconceivable that it could go it alone in breaking up the banks," argues Michael Raffan, head of Freshfields Bruckhaus Deringer's financial services group.

Of the Commission members – made up of chair Sir John Vickers; former gas regulator Clare Spottiswoode; ex-JP Morgan banker Bill Winters, ex-Barclays chief executive Martin Taylor; and Martin Wolf, The Financial Times columnist – only Winters is reported to be against a retail/investment split in banking.
But an indication of the eventual outcome could lie in the timing. "The UK Commission on Banking comes really late," observes former UBS chairman Peter Kurer. "It's doing the work that the US Congress has already done. By the time the final report is issued in over a year's time many of the big decisions will have been made."