FSA to become Bank of England subsidiary
Reports that the coalition government is backing away from the abolition of the Financial Services Authority as an independent financial regulator seem to be premature.
My understanding is that the part of the FSA that monitors banks, insurers and other financial institutions to prevent them taking excessive risks will become a formal subsidiary of the Bank of England.
I expect this to be announced by the Chancellor, George Osborne, in his first Mansion House speech on Wednesday evening.
In other words the Bank of England would have ultimate responsibility for banking regulation and supervision as the "owner" of the reconstructed and slimmed-down FSA. But the financial regulator would retain its own board and - to an extent - its own identity.
This transfer of responsibilities to the Bank of England would represent a symbolic and substantial reversal of one of Gordon Brown's first acts as chancellor in 1997, when he removed banking supervision from the Bank of England and merged it with other City regulatory bodies to create the FSA.
That said, my impression is that Mr Osborne is trying to preserve a semblance of independence for the FSA by putting its financial regulatory activities into a legally separate subsidiary of the Bank of England, rather than into just another operating division of the Bank.
Within the Bank of England, a new Financial Policy Committee would also be created, consisting of Bank executives with a direct responsibility for financial stability and senior representatives from the FSA.
This Financial Policy Committee's primary duty would be to maintain financial stability, or avoid the kind of crisis we experienced in 2007 and 2008 when bank after bank went to the brink of collapse and we came close to the meltdown of the financial system.
The committee would have a set of so-called "macro-prudential tools" to deter banks from providing credit when there are signs that the economy or parts of it - such as the housing market - are overheating.
It would also have the new financial supervision subsidiary of the Bank of England under its sway. And it would expect to be the ultimate decision making body for regulatory decisions affecting the activities of the biggest banks and insurance companies.
So, for example, if a big bank wanted to buy another big bank, the Financial Policy Committee would determine whether that should be allowed or whether it should be sanctioned only subject to conditions designed to minimise the risks of the deal.
The ambition would be to avoid a repetition of the kind of regulatory disaster that occurred in 2007, when Royal Bank of Scotland was permitted by the FSA to buy the rump of the giant Dutch bank ABN Amro, and did so in a way that made the enlarged bank too dependent on unreliable wholesale finance and slashed the amount of capital RBS was holding relative to assets as a buffer against losses.
That takeover by RBS was the primary reason why RBS had to be rescued by taxpayers in Britain's biggest ever financial bailout in the autumn of 2008.
George Osborne has long been critical of the tripartite regulatory system imposed by the previous government, in which oversight of the financial system was shared between the FSA, the Bank of England and the Treasury.
Osborne and other critics of the tripartite system argued that it was cumbersome and meant that in practice no one could be held sufficiently accountable when a big bank (or in practice, a whole series of banks) ran into difficulties.
Under Osborne's proposed reforms, the buck will very firmly stop with the Bank of England. The Bank of England will be to blame if there's another banking calamity that tips the UK back into recession.
Now you may think that none of this is news - in that these reforms are very much in the spirit of the regulatory changes Osborne proposed when shadow chancellor.
But ever since the coalition government was created last month, it has become widely believed in the City that Mr Osborne had dropped his previously announced commitment to "abolish the FSA" (which was the phrase used in a Tory policy document, "Change for the Better in Financial Services", published in April).
The supposed evidence that Mr Osborne had dropped his determination to dismantle the FSA was that the Tories' coalition agreement with the LibDems made no mention of plans for the FSA at all. Instead, all that document said was that "we will bring forward proposals to give the Bank of England control of macro-prudential regulation and oversight of micro-prudential regulation."
That vague formulation, "oversight" of micro-prudential regulation, suggested that the FSA might be preserved to a large extent.
But in the end, Mr Osborne has taken the view that there needs to be a cultural revolution to toughen up the supervision of banks and other financial institutions - which can only be achieved by separating that activity from consumer protection and also by putting the Bank of England into the driving seat.
Anyway, enough of the hermeneutics.
Related reforms likely to be announced by Osborne are the separation of the FSA's consumer protection operations into a new Consumer Protection Agency and of its enforcement activities into a new Economic Crime Agency.
However there are plenty of unanswered questions. These include:
1) Will Osborne set up the new operating arrangements for the Bank of England and FSA in shadow form, so that the system is working in an informal sense relatively quickly prior to the necessary legislation going through parliament?
2) What will be the relationship between Paul Tucker, the deputy governor of the Bank of England in charge of financial stability, and the new regulatory subsidiary of the Bank of England?
3) And, is it remotely possible that one big beast in the financial policy jungle, Lord Turner, chairman of the FSA, would agree to be answerable to another big beast, Mervyn King, governor of the Bank of England?
Mervyn King as Adair Turner's boss? Hmmm. That doesn't sound like a sustainable or even plausible relationship.