Bank watchdog warns lenders to respect 'intention' of UK regulation
The Bank of England watchdog has warned lenders to steer clear of financial loopholes and urged them to respect the "intention" of UK regulation.
Sam Woods, the Bank's deputy governor and chief executive of prudential regulation, said he was "especially mindful" that firms would always be one step ahead of regulators, despite attempts to keep the financial "rule book" up to date.
He said the "coming phase" of financial supervision would require supervisors who can judge whether companies and their managers "meet the intention as well as the letter of the regulation".
"Some innovation by financial institutions in response to regulation will be intended by regulators, or, if not intended, at least benign.
"However, some innovation is pure regulatory arbitrage - that is, action taken by firms to reduce specific regulatory requirements without any commensurate reduction in their risk."
He said one example was the way companies were using "special purpose vehicles", agency structures, derivatives and collateral swaps for off-balance sheet financing and debt.
"History tells us that the commercial incentives of firms will create pressures to find ways to minimise the impact of those rules."
Mr Woods said some companies have taken advantage of loopholes around liquidity and solvency requirements, which effectively help them sidestep regulations meant to safeguard the financial system.
He warned that the watchdog would carefully examine lender proposals that fail to address the heavy risks they intentionally - or inadvertently - entail.
"Some amendments might meet the letter of the regulation, but they are designed to circumvent the spirit.
"The PRA (Prudential Regulation Authority) will continue to scrutinise proposals by firms which seek to strengthen their balance sheets but which pay little attention to the additional risks they carry, " he said.
To remain "fit for purpose", the deputy governor said the PRA's framework had to be "responsive to changes in behaviour and structure" of the financial system and be able to identify any "gaps, faults or incoherence" that can lead to "perverse behaviour".
His comments were originally prepared for the Building Society Association's annual conference in May, but were delayed after the General Election was called as it fell in the "purdah" period which restricts government announcements in the weeks before a vote.