New financial regulators set out how they will respond to their own failures

The Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) are both legally required to investigate possible instances of regulatory failure and provide reports of their findings and recommendations to the Treasury for publication. The tests, which are set out in the Financial Services Act 2012, are different for each regulator and relate to their respective statutory objectives.

"A regulatory system that removed all risk would be prohibitively expensive and could stifle innovation and competition," said Martin Wheatley, chief executive of the FCA. "The instances where we investigate and report to Treasury will be significant events and serious failures, when things have gone badly wrong, and [our] paper sets out how we will identify and deal with these exceptional cases."

Established on 1 April 2013, the FCA and PRA took over the regulatory functions of the previous Financial Services Authority (FSA). The PRA, a subsidiary of the Bank of England, is responsible for most of the day-to-day regulation and supervision of banks, building societies and insurers. The FCA is responsible for conduct and compliance, as well as the prudential supervision of firms that are not otherwise regulated by the PRA.

The FSA published three reports in which it considered the effectiveness of its regulation of firms and markets following the financial market crash in 2008. These concerned its handling of the failures of Northern Rock and RBS, and a report into its handling of allegations of LIBOR manipulation. However, it was never subject to a formal framework setting out what should or should not be regarded as a regulatory failure.

According to its statement of policy, the FCA's procedures will apply from 1 April for events arising on or after this date. It states that it only expects to have to carry out a formal investigation and report to the Treasury in "exceptional circumstances". Failures will be considered for severity on a case-by-case basis, with "organisational deficiencies" more likely to constitute a serious failure. The policy will be reviewed in one year, particularly to take account of the changes in scope of the FCA to regulate consumer credit from April 2014. After this, the regulator intends to review the policy "periodically".

Under the Financial Services Act, regulatory failure on the part of the FCA will be taken to have occurred either when it fails to secure an appropriate degree of protection for consumers, or when its failure had or could have had a "significant adverse effect" on the integrity of the UK financial system or on effective competition in the interests of consumers. The event must have occurred, or have been made worse, because of a serious failure of the regulatory system or on the part of the FCA. The statement includes examples of situations where this may or may not have occurred.

There are three conditions which trigger the requirement for the PRA to carry out a statutory investigation. These are "relevant public expenditure", such as financial assistance or expenditure incurred by the Treasury; events which have or could have had a "significant adverse effect on the safety or soundness" of an authorised firm; and where the protection of policyholders is at risk. The PRA will be required to carry out an investigation if the event might not have occurred, or the effect of the event might have been reduced, without a "serious failure in the scope or design of the system of regulation or the operation of that system".

In its statement of policy (6-page / 181KB PDF), the PRA said that an investigation would not be trigged automatically if one of the statutory events occurred. This was because of "the important principle, rooted in the PRA's objectives, that it is not the PRA's role to prevent all firm failures, nor to protect all policyholders in full in all circumstances".