Innovation and regulation - striking the balance - speech by David Bailey

Introduction

Good morning. I would like to thank Risk.net for inviting me to speak today.

I will take this opportunity to talk about innovation in financial services. My focus will be on the role the PRA can play in fostering innovation in the UK banking and insurance sectors; and how doing so can support firms becoming more resilient as well as promoting competition, UK competitiveness and growth more broadly.

I will particularly focus on the impacts of our Secondary Competitiveness and Growth Objective (SCGO). This came into effect in August 2023 and has had a material impact on how we make policy, and on the policy outcomes we deliver. In advancing the SCGO, we are working closely with the government to support its focus on growth; the importance of which was emphasised to us through HMT’s recommendations letter to the PRA, and an exchange of letters between the Prime Minister and Sam Woods – our CEO – at Christmas.

To date, much of the external focus on the SCGO has been on how the PRA can, through greater efficiency and streamlining of regulation, reduce the regulatory burden for firms. We have been putting lots of energy into this, for instance by reducing the reporting requirements for insurers we inherited from the EU by around a third through the Solvency UK reforms that came into effect earlier this year. We are also working on major amendments to our remuneration requirements for banks that will enhance the sector's competitiveness while maintaining its resilience. That last point about maintaining resilience is key, as it supports financial stability which in turn underpins sustainable economic growth.

But another important aspect is the role that regulation plays in fostering innovation. Like innovation in other sectors, for example the advent of smartphones, innovation in financial services can lead to radical changes in the world around us. Just look at the evolution of how we make payments through cash, online and contactless payments to the new forms of digital money that we are now seeing. But, as with smartphones, innovation in financial services can require significant upfront investment to pursue – and is not without risks.

At the PRA, we are committed to creating an environment where innovation can flourish safely and where households, business and markets can reap the benefits. In doing so, there is a careful balance to strike between writing rules to provide firms with the certainty they need to invest with confidence, whilst providing enough flexibility to create space for innovation to flourish. We are continuing to think carefully about this balance, and our stakeholders have an important role to play in helping us get it right.

I will therefore begin by providing some background on the SCGO, including the work we have done to embed it at the PRA, and how it is impacting policy outcomes. I will then turn to innovation, explaining where it sits within our approach to the SCGO, and outlining some of the ways in which it can support our objectives. I will then discuss some of the risks and costs involved and share some reflections on how our approach to regulation can mitigate those risks. Finally, I will touch on how you, and our broader set of stakeholders, can engage us on the topic of innovation, and the important role stakeholder input plays in shaping our approach.

Background on the SCGO

The SCGO mandates the PRA, so far as reasonably possible, to “facilitate subject to aligning with relevant international standards – (a) the international competitiveness of the economy of the United Kingdom (including in particular, the financial services sector through the contribution of PRA authorised persons), and (b) its growth in the medium to long term”. As with the Secondary Competition Objective which we have had since 2014, it is engaged when the PRA exercises its general functions, such as making rules and technical standards, or determining the general policy and principles governing our functions. Therefore, it is engaged when we set our approach to supervision but does not directly apply to firm specific supervisory decisions. Our secondary objectives are also engaged only when we discharge our general functions in a way that also pursues at least one of our two primary objectives: the safety and soundness of firms we regulate, and on the insurance side, policy holder protection. It is also important to note that there is a complementary relationship, rather than a trade-off, between our primary and secondary objectives. Building on what I said earlier, sustainable economic growth over the medium to long term requires a resilient financial sector to support it.

We have embedded the SCGO at the heart of our policymaking processes, which has led to a step change in how we make policy. We have set out our strategy for advancing the SCGO, which is detailed in the Policy Approach we published earlier this year and our Annual Report. This included establishing a centre of expertise for the SCGO within the PRA which has delivered training across staff in policy, supervision, and authorisations to promote best practice. And our policy papers set out clearly how any proposed initiatives would impact on competitiveness and growth, with our governance committees, such as the Prudential Regulation Committee (PRC), regularly reviewing progress.

To provide an independent assessment of how we are doing, last year The Bank’s Independent Evaluation Office (IEO) assessed our progress in embedding the SCGO. The IEO’s report noted good progress and ‘numerous positives’ including the investment the PRA has made on its approach to the SCGO and the traction gained across all levels of the PRA. It also made recommendations, such as building on existing networks to ensure that intelligence from inside and outside the Bank informs policymaking, which we have made good progress in addressing.

Our enhanced consideration of competitiveness and growth have also had a material impact on the policy we have delivered. These included actions we have taken such as:

• Basel 3.1, where we are implementing international standards to make our bank capital requirements more reflective of risks taken by firms. In doing so we tailored our final rules to reflect UK specific circumstances, for instance to lower capital requirements vs the international standards in order to support lending to SMEs and infrastructure projects.
• Solvency UK, where we simplified complex requirements inherited from the EU, and reformed Matching Adjustment rules, allowing life insurers to invest more in UK productive investments.
• Removing the bonus cap, which had distortionary effects such as inflating bankers’ base salaries. Its removal is already boosting the UK’s competitiveness internationally.
• Setting up, jointly with the FCA, a New Insurer Start-up Unit, sitting alongside our existing New Bank Start-up Unit, to provide information and support for those thinking of setting up a new insurer in the UK. This reduces barriers to entry, therefore facilitating effective competition and innovation.

And there is much more in the pipeline, including our plans for:

• Finalising our proposals for a ‘Matching Adjustment Investment Accelerator’ which will make it easier for insurers to take advantage of UK productive investment opportunities more quickly.
• Finalising rules to improve the UK framework for Insurance Special Purpose Vehicles, including simplifying and accelerating the authorisation process. And we are pleased to be supporting the Government as it finalises its views on captive insurance and stand ready to play our role.
• Consulting on streamlining bank data reporting by eliminating little-used data collections, reducing the burden on firms while maintaining effective supervision and policymaking. This would build on the material reductions already implemented for insurers.

I could go on as there is much more in our pipeline, but there is no need because we will outline much more detail in our second annual report on how we are advancing our secondary objectives, which will be published next month. Instead, I want to focus on innovation specifically.

So, what about innovation?

These reforms will bring real benefits. But I said I would focus on innovation. In our Policy Approach document, which we published in February, we described three regulatory ‘foundations’ which represent the ways our regulation underpins the UK’s growth and competitiveness. These are: (i) maintaining trust among firms in the PRA and UK prudential framework; (ii) adopting effective regulatory processes and engagement; (iii) adopting a responsive and responsibly open approach to risks and opportunities. Innovation plays into all three of these and supporting it is consistent with advancing both our primary and secondary objectives.

Innovation can:

• Enable new or more tailored products and services; allowing firms to do new things or find different ways to use existing products. More effective financial products and markets can support the financing and risk transfer needs of households and businesses as well as strengthen firms’ competitiveness and profitability, and through that their safety and soundness. We see this, for instance, with usage-based insurance – where observed behaviour (e.g. bad driving) is reflected in the insurance premium, thereby ensuring that pricing is better tailored to actual risk, at the same time as providing an incentive to reduce riskier behaviours.
• Enable firms to do existing things better and more efficiently. This reduces costs for end users, freeing up their resources to invest in the growth of their business. It can also help financial firms to operate more profitably and compete more effectively, both domestically and internationally. We see this in the increasing usage of AI to reduce manual processes within firms, in how Machine Learning is starting to help inform insurance pricing, and through evolutions in payments technology.
• Facilitate the broader provision of goods and services to sectors of the market that might otherwise be underserved. For example, by reducing the cost of non-standard products, such as those tailored for SMEs; or through innovations like peer-to-peer lending, which have increased access to credit. Through channels such as improved access to credit, this can support investment in the wider economy, in turn supporting growth over the medium to long term.
• Help making the financial system stronger and more resilient. For example, via the use of third-party services, including cloud-based ones, to replace inefficient legacy in-house systems and processes with more resilient and flexible ones.

This underlines that if we support innovation in the right way, it will help strengthen our financial system, whilst also making it more diverse, efficient and competitive.

Innovation is neither cost nor risk-free

This shows there are many reasons for us to support innovation. But, and there is inevitably a ‘but’, innovation comes with costs and risks both to individual firms and the system. It often requires significant upfront investment, often with uncertain outcomes, as well as long-term planning. This means that the upfront and transition costs can be high. For example, the financial sector's spending on AI is projected to grow from $38 billion worldwide in 2024 to $190.3 billion in 2030.^{footnote [1]} This has been assessed to have the potential to cut operating costs in the financial industry by 22% - representing a total of $1 trillion in overall savings by 2030.^{footnote [2]}

There are also risks that the PRA needs to consider. These risks can be financial, arising through new or more complex risk profiles of innovative products. They can be operational, for example as firms transition to new technologies or embed dependencies on new third parties. Or they can be conduct-related as financial services are delivered to new sets of consumers or through different ways.

What does this mean for the PRA’s approach to regulation?

This means that we need to take a thoughtful approach to our regulatory framework, if we are to support innovation by giving firms sufficient certainty and confidence to invest in new technologies and approaches in a way that ensures that risks are appropriately managed. And there is a spectrum of ways in which we could do that through our prudential rulemaking.

On one end of that spectrum, we could set out detailed rules at an early stage to provide certainty to firms on our expectations and to ensure that innovations are well understood, trialled and tested. An example of this approach from another sector might be medicines where, for very clear and good reasons, new products placed on the UK market require rigorous testing, product assurance and pre-approval from the regulator before going to market. The benefit of this approach is that it gives firms certainty on the approval process, and the standards to go to market. But it also requires a potentially significant investment from firms, both from a cost and time perspective, to get products to market.

At the opposite end of that spectrum, we could allow innovation to flourish freely, guided by limited regulation consisting of, for example, very high-level principles or guidelines. The benefit of this approach is that it creates ample space for innovation, whilst allowing regulators to be more flexible and responsive. However, it also creates more opportunities for risks to escalate and crystallise at speed, potentially forcing regulators to step-in quickly. For example, we have seen the potential harms of social media – an innovation which has significantly changed the way we interact and communicate – crystalise and prompt a retrospective response from governments internationally.

Between these two examples, there are a range of points we could land on this spectrum. Where we strike the balance is a genuine choice: one which might be guided by the innovation at hand – it doesn’t have to be the same approach every time. But in general, my view is that the PRA’s approach to prudential regulation has traditionally aimed to be more toward the second end than the first – although I recognise that not all of our stakeholders may agree with that assessment based on their own experience.

Take AI as an example of my point. Our approach has, to date, been open, flexible, technology agnostic and informed by extensive engagement with industry and other stakeholders. We have existing rules and standards in areas like model risk management and third-party outsourcing. These are established areas of policy and, informed by all our external engagement, we think they can apply to AI in the same way as they do to other technologies and processes. In line with that we have not, so far, concluded we need to develop detailed rules on the usage of AI as the technology – and its use by banks and insurers – evolves. We keep a careful eye on it, but we also don’t want to unnecessarily get in the way of the benefits it may bring.

However, there are also examples where it might be more appropriate to start more towards the restrictive end of the spectrum, while evidence is gathered to see if standards can be relaxed over time. The prudential treatment of banks’ exposures to cryptoassets, and specifically those with features associated with heightened price volatility and where investors could lose the entirety of their investment, is an example in this space. Here, of course, we are being informed by the standards that have been developed internationally, in this case by the Basel Committee on Banking Supervision, which we remain committed to implementing in the UK. In this area, we plan to bring forward our proposals in 2026.

I think this demonstrates it’s a genuine choice we have available to us every time we look at a new innovation. But our general approach seeks to be alert and responsive to innovation. We have various tools at our disposal to help us, for example our horizon scanning work. Part of our work programme focuses on the emerging trends that might ultimately prompt a regulatory response; and this supports regular discussions at senior committees, such as the PRC and the Financial Policy Committee (FPC), who consider whether the risks are well understood, and whether our response is appropriate. Areas of particular focus are then outlined via our Supervisory Priorities letters, our PRA Business plans and our Financial Stability Reports.

We also use regular industry engagement to understand the demand to innovate, for example through regular roundtables and conferences, as well as ad-hoc meetings and supervisory engagement. Through these, we seek to understand where firms are looking to evolve how they operate, or the services they provide, so we can consider how our regulation can support those efforts develop in a resilient way. And to inform our overall approach to innovation we arranged a bespoke roundtable for industry participants. A key point emphasised at this was the benefits of a collaborative approach, involving ongoing engagement with industry on specific topics. We have increased our focus here by hosting more roundtables and Subject Expert Groups on specific themes or issues. This is supplemented by specific groups like the recently launched AI Consortium which we chair jointly with the FCA and has been established by our colleagues in the Bank’s FinTech Hub to act a platform for public-private engagement to gather input on the capabilities, development and use of AI in UK financial services.

Informed by that engagement we then decide what an appropriate regulatory response should be. To give a few examples:

• The Matching Adjustment Investment Accelerator I mentioned earlier, where we wanted – in a measured and responsible way – to facilitate firms to get capital benefit earlier by adding assets to their Matching Adjustment portfolio, thereby reducing barriers to rapid investment in projects which support growth in the UK.
• The Digital Securities Sandbox (DSS), a regulated live environment that has been created by my Bank of England colleagues, in partnership with the FCA, to explore how developing technologies could be used by firms in a controlled way to undertake the activities of notary, maintenance and settlement for financial securities. Good progress has been made here with strong applications received. The format of the DSS has allowed us to switch off rules and look at a mix of activities that would otherwise not be possible to be performed by a single legal entity.
• Critical Third Parties – such as Cloud Service Providers – where the reliance on a small set of providers, by the firms we regulate, had grown to the extent we felt it necessary to step in with formal regulation to mitigate risks to financial stability.
• Stablecoins and tokenised deposits – we have worked closely with the Bank’s Financial Markets Infrastructure Directorate to evaluate the risks and opportunities of new forms of digital money. In doing so we have considered the related implications and incentives created by the various regulatory frameworks involved. Our goal is to ensure that similar products with similar protections face comparable regulation. This would ensure that deposit-taking entities, who we have previously said should only provide innovations in the form of deposits (for example in tokenised form), can compete openly with non-banks issuing systemic stablecoins under the Bank’s new regulatory regime. This supports innovation, enabling both incumbent and new firms to compete while ensuring that customers are able to use different forms of digital money with confidence.

So far, I think this flexible type of approach has served us well given the types of challenges we have faced. But are keeping our approach under review, to ensure that we strike a sensible balance as the world evolves around us. Our stakeholders play an important role in helping us strike that balance, so I welcome thoughts and feedback on how we might adjust our approach as we go forward.

Innovation within the PRA

Before I conclude, I wanted to say a word on our use of innovation within the PRA. We are very conscious that technological developments and innovations can have a transformative effective on what we do – allowing us to be faster, better, more efficient and more targeted in aspects of our regulation and supervision. As one example, my colleague James Benford, the Bank’s Chief Data Officer gave a speech last year setting out our approach to leveraging AI in a safe, ethical and effective way to support our work delivering monetary and financial stability. Within the PRA this includes using Natural Language Processing to study the content of our regulation and help enhance how we draft our rules and communicate about them; leveraging AI to gain supervisory insights from large quantities of unstructured data – a task that was previously high intensity and manual; and using generative AI to summarise meetings and documents. But before anyone gets concerned about being regulated by technology alone, our approach embeds the critical importance of there always being a human in the loop in our use of AI.

Conclusion

In conclusion, advancing the SCGO and supporting growth within the financial sector, is complemented and underpinned by our focus on safety and soundness and a resilient financial sector. It requires a thoughtful and effective regulatory approach. Through this we will continue to deliver changes that lessen the regulatory burden on firms by making regulation more efficient and proportionate. But it is also important we also focus on how we can support the firms we regulate to innovate to do better things, and to do things better. We will seek to do so in a flexible and responsive way; relying on close engagement with industry to inform the balance we strike.

Thank you.

I would like to thank Andrew Bailey, Nat Benjamin, Sarah Breeden, Emma Butterworth, Andrew Carey, Pavel Chichkanov, Phil Evans, Christopher Goodspeed, Lisa Hammond-Robinson, Sasha Mills, Tom Mutton, Harsh Mehta, Adeshini Naidoo, Csongor Osvay, Rob Price, Alan Sheppard, Elisabetta Vitello, Vicky White, Sam Woods for their assistance in preparing these remarks.