Twin Peaks Revisited - Centre for Competition Law and Policy

Michael Taylor

Outline
� Does the structure of regulatory agencies matter?
� The “Twin Peaks” analysis
� Functional despecialisation and financial conglomerates
� From analysis to structure
� Twin Peaks in practice
� Why did the UK choose a single regulator?
� Lessons of the crisis
� UK reforms

Does regulatory structure
matter?
� Sometimes dismissed as “rearranging the deckchairs
on the Titanic” (Martin Wolf)
� Temptation for politicians to change regulatory
structures after a crisis to be seen “to do something”.
� Other factors influencing effective supervision:
� Clear objectives
� Independence and accountability
� Adequacy of resources
� Effective enforcement powers
� Comprehensiveness of regulation (Abrams/Taylor 2000)

But structure not irrelevant
� Comprehensiveness
� Ensuring no significant market or intermediary escapes
effective supervision
� Cost efficiency
� Avoid duplication of resources/activities
� Coordination
� Ensure that all aspects of a firm’s operations are
adequately supervised
� Especially important in crisis management

The traditional structure
� Institutional supervision or combination of
institutional and functional
� Institutional – for prudential soundness, e.g. separate
regulations for banks, insurers, securities firms
� Functional – by product type – for consumer
protection purposes
� E.g. UK system prior to 1997
� Banking Act 1987
� Financial Services Act 1986
� Insurance Companies Act 1982

Justification for traditional
approach
� Clear separation/segmentation of financial sector
along industry lines
� In some cases segmentation due to legislative decree
(e.g. Banking Act 1933 in US), in others due to custom
and practice (UK pre-Big Bang).
� Banks the only systemically important financial
institutions: required special level of supervision and
regulation and oversight usually provided by central
bank (as lender of last resort)

Traditional approach outmoded
� Changes in industry structure
� Changes in nature of products
� Neither institutional nor functional approaches were
adequate

Changing industry structure
� Financial conglomerates
� Abolition of formal (Glass-Steagall) and informal
(U.K.) restrictions on investment/commercial banking
combinations
� Bank-insurance linkages becoming commonplace
� How to obtain a “group-wide” perspective to monitor
their prudential soundness? (Tripartite Group,
Supervision of Financial Conglomerates, 1995)

Changing nature of products
� New financial products that overlapped conventional
deposit/insurance/securities boundaries
� E.g. Credit Default Swaps – credit or insurance?
� Especially problematic for consumer protection – who
regulates which product?
� But also a systemic dimension – OTC (over-thecounter)
derivatives markets increased the
interconnectedness of institutions, banks and nonbanks

Twin Peaks analysis vindicated
� The crisis has shown that:
� Industry concentration – in the form of financial
conglomerates or “Large Complex Financial
Institutions” – now an established part of the financial
landscape
� A wide range of firms (not just banks) are potentially
systemically important institutions (Lehman, AIG)
� To this extent Twin Peaks analysis has been justified:
the chain of collapse ran through non-banks, “too
interconnected to fail”

The Twin Peaks alternative
� Taylor (1995); Goodhart (1995); Australian Financial
System Inquiry (1996)
� Structure regulation according to objective or purpose
� Two regulatory agencies
� Financial stability = ensure the prudential soundness
of financial institutions irrespective of legal form
� Consumer protection = ensure adequate
disclosure/consumer protection for all products
irrespective of legal form
� What role for the central bank?

Twin Peaks in Practice
� Twin Peaks model adopted first in Australia following
the Financial System Inquiry (“Wallis Commission”)
which reported in 1996
� Established two agencies – APRA and ASIC
� Banking supervision function removed from RBA.
� Netherlands followed in 2002.
� Dutch Twin Peaks model kept central bank (DNB) as
prudential regulator for banks, insurers & pension
funds
� New consumer protection regulator - AFM

UK single regulator
� Soon after May 1997 General Election the new Labour
government announced creation of a single regulator
(FSA) combining functions of nine previously existing
regulators.
� Justification for the FSA drew heavily on the Twin
Peaks analysis
� But Twin Peaks was rejected in the UK in favour of a
single integrated regulator
� Financial Services and Markets Act 2000
� FSA came into being before legislative enactment

Why was the FSA established?
� Justification provided by Brown (as Chancellor)
echoed Twin Peaks – “blurring of boundaries”
� But Twin Peaks rejected because prudential and
consumer protection regulation had strong synergies –
involved many of the same issues (e.g. management,
systems and controls) (Briault, 1998)
� Real reasons were more political:
� Labour distrust of Bank of England
� Parliamentary timetable

UK’s system pre-crisis
� Clear separation of roles between BoE and FSA.
� BoE focused on monetary policy.
� FSA focused on micro-prudential supervision and
(especially) consumer protection.
� Who was responsible for financial stability?
� Who was responsible for crisis management?
� Tripartite arrangements (Treasury, BoE, FSA) were
unwieldy and wilted in heat of crisis. No one in overall
charge.

Lessons for regulatory structure
� Twin Peaks superior to a single regulator because it
permits each agency to focus on a single objective:
� Political priority likely to be given to consumer
protection versus prudential regulation (House of
Lords, 2009)
� Different skills required by consumer protection and
prudential regulation
� Giving “equal billing” to central bank and regulatory
agency did not work in practice. Recipe for delayed
decisions and lack of coordination (cf. Northern Rock).

New lessons from the crisis
� Importance of good crisis management arrangements:
� Ensure coordination between provider of liquidity
support (central bank) and supervisory agency
� Role of Finance Ministry (Treasury) as provider of
“capital of last resort”
� Need to deal with the “Too Big to Fail” problem.
Some large firms operate without effective market
discipline because the spillover effects of bankruptcy
are too great.

Return to Twin Peaks
� In June 2010 the UK Coalition government announced
that it was committed to establishing a “Twin Peaks”
structure.
� The Prudential Regulation Authority as prudential
regulator under the BoE; a separate Consumer
Protection and Markets Authority will be established
(HM Treasury Consultative Document, July 2010)

Justification of UK reforms
� Improved focus on the objectives of regulation: aim to
create a system in which risks to the financial system
are at the forefront of supervisory action.
� Improved crisis management arrangements: as a
subsidiary of the Bank of England, PRA will have close
links with the central bank. BoE in the lead in most
crisis episodes.
� Improved arrangements for dealing with TBTF. Focus
on system stability, not on preventing the failure of
individual firms.

Outstanding issues for the UK
� Central to the new UK approach will be steps to
reinforce market discipline and therefore to reduce the
Too Big to Fail problem.
� This will require mechanisms to ensure the orderly
failure of problem banks.
� Banking Act 2009 first step in this direction. Other
elements are Recovery and Resolution Plans (aka
living wills) and cross-border resolution arrangements.
� Reforms also intended to emphasize
“macroprudential” dimension

Twin Peaks Revisited
� FSA looks like a “failed experiment”
� Single regulator was probably never appropriate for a
financial system of the size and diversity of the UK
� Much more attention to crisis management was
required
� Tide turning back in favour of central bank
involvement in regulation, with Twin Peaks as
preferred structure (Nier, 2010)

Bibliography
� Abrams and Taylor “Issues in the Unification of Financial Sector Supervision”
in Enoch, Marston & Taylor (eds) Building Strong Banks (IMF, 2002)
� Financial System Inquiry, Final Report (Australian Treasury, 1996)
� Goodhart, C.A.E., “Some Regulatory Concerns”, LSE Financial Markets Group
Special Paper, 1995
� House of Lords, Economic Affairs Committee, “Banking Supervision and
Regulation”, June 2009
� H M Treasury, “A New Approach to Financial Regulation: Judgment, Focus and
Stability”, July 2010
� Nier, Erland, “Financial Stability Frameworks and the Role of Central Banks”,
IMF Working Paper, WP/09/70
� US Treasury Department, “Blueprint for a Modernized Financial System”,
March 2008
� Taylor, Michael “’Twin Peaks’: A Regulatory Structure for the New Century”
(London, Centre for the Study of Financial Innovation, 1995)

michaelwilliamtaylor@yahoo.co.uk