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Source: The Economist Intelligence Unit

Speech by Paul Tucker, Deputy Governor Financial Stability, Member of the Monetary Policy Committee and Member of the Financial Policy Committee, at the British Bankers’ Association Annual Banking Conference, London, October 2012

Paul Tucker considers the factors driving excessive risk-taking in the financial system leading up the crisis, and outlines some of the key aspects of the reform of banking. He says “the changes are profound”. But in “overhauling the ‘rules of the game’ for global finance”, he emphasises that the goal of the international authorities is not to abolish risk or risk-taking. “We need to find broadly the right balance between, on the one hand, safety and, on the other hand, the contribution that sound and honest finance can make to economic prosperity”.

Paul Tucker notes the way increasing leverage fed upon itself in the run-up to the current crisis, and says it poses “deep but pressing questions about the efficiency and effectiveness of capital markets in monitoring and pricing risk”. And while ‘Too Big To Fail’ is “the biggest problem we have to crack”, he says moral hazard isn’t a complete explanation. Rather, it was compounded by agency problems, myopia, complexity obscuring the risks in the system as a whole, and accommodative global monetary conditions. Together, these factors combined, he says, to create “a heady mix … which the prevailing regulatory regime was singularly ill equipped to address, and in some respects had done much to create through inadequate capital requirements and an absence of liquidity requirements. In fact, a toxic mix.”

Paul Tucker highlights six key aspects of the domestic and international reform programme pertinent to the banking industry. “First and foremost, we need holders of bank debt to be exposed to losses when banks fail.” He states the imperative of having deposit-takers that can be resolved in an orderly way, and the significance of the UK government’s ring-fencing plans in this context. But in addition, he says, the capital markets need sound intermediaries which, if they become distressed, can expire safely or whose viable parts can be resurrected. Bail-in, set to become part of UK law over the next few years, is, he says, one way of doing this. “The prospect of taking losses via resolution gives debt holders a strong incentive to monitor banks’ risk taking. That will be a first order change for the financial system.”

Second, Paul Tucker says the authorities need to consider whether to require management to be paid to a significant extent in subordinated debt, an idea recently endorsed by the Liikanen Committee. “Having managers exposed to instruments whose value depends on the survival of their firm would give them a healthy incentive to maintain a safe and sound bank”. In addition, he says, there should be a review of the structure of remuneration for desk-level bankers – tying pay to the medium-term success of the firm. “Putting it bluntly, that would make it less easy to get rich quick irrespective of the quality of business transacted or the compliance culture in their part of the firm”. This, he says, points to revisiting the terms and scope of the existing codes on remuneration of the G20 Financial Stability Board, the European Union and, in the United Kingdom, the Financial Services Authority.

Third, Paul Tucker highlights measures to address industry structure and system resilience. These include the UK’s ring-fencing plans, which will he says make it somewhat easier to see what is going on, and help establish different cultures in different lines of business. “Within domestic commercial banking, we need somehow to unwind some of what I think of as the industrialisation of retail and business banking that occurred during the years of plenty. Branch and regional banking came too close to being seen as an exercise in sales and marketing … Banking is about credit judgments. Boards need to think about how to re-inject that into the role of banks’ front line managers.” And, he says, competition policy may matter too: with more domestic competitors around, the wider effects of an individual bank failure would in all likelihood be smaller. In this vein, he notes the Bank’s wish to reduce barriers to entry to the banking system somewhat by removing barriers to exit, and the role of the UK’s Special Resolution Regime in this context.

Fourth, Paul Tucker notes changes in prudential regulation, in particular higher risk-based capital requirements and a cap on leverage. As well as providing a bigger buffer against loss, higher capital requirements will, he says, also affect behaviour, depressing the headline return on equity and likely prompting shareholders to “demand a larger share of the cake”. He notes the need for robustly-determined risk-weights, and advocates a debate on introducing mandated floors on risk weights in Basel as a means of containing the risks from complexity. But he warns that it would not be sensible to rely entirely on a simple regulatory constraint: “history teaches us that they do not work on their own”. The new Basel package is, he says, an attempt to use simple measures to put bounds on the consequences of flaws in more complex measures, which were themselves designed to avoid the perverse incentives to hold only very risky assets created by the previous generation of simple measures. But “more will need to be done in the years ahead to simplify and underpin the Basel regime”.

Fifth, Paul Tucker discusses the role of microprudential supervision under the UK’s new Twin Peaks structure. The advent of the Financial Conduct Authority will, he says, “finally give London a dedicated securities regulator a quarter century after the Big Bang that made it so necessary”. Meanwhile, the future Prudential Regulation Authority will work to “transform the climate of prudential regulation … We want this to be as collaborative, open and honest as possible – a different relationship between banks and their supervisors. One that revolves around penetrating and forensic analysis of the business and, where necessary, frank discussions with senior management and the board. Not a negotiation. And a regime where the Bank’s Prudential Regulation Authority has the powers to underpin pursuit of material concerns about safety and soundness, based largely on whether firms meet the broad statutory criteria – the Threshold Conditions – for being authorised.”

Finally, Paul Tucker highlights the significance of macroprudential policy: keeping the rules of the game up to date and leaning against exuberance. This, he notes, is precisely the remit of the FPC. And although most of the Interim FPC’s deliberations to date have concerned bank capital adequacy, he says he expects the FPC’s longer-term focus to be as much on the capital markets and, thus, the policies of the FCA. But, he says, taking away the punchbowl will be unpopular. “That is why the current debates in the UK Parliament about the Bank of England’s new Financial Policy Committee are so very important: in a word, legitimacy.”

In conclusion, Paul Tucker states that “work by the international central banking and regulatory community to make the system safe and sound has made real progress in recent years, but it is not complete and absolutely must continue with energy … We may not be able to abolish the occasional waves of optimism that grip humanity and the tendency to excess they set off. But we can and must dampen their effects on the financial system and economy … Markets will, in time, forget about the risks, but the system will be safer if we succeed in building official institutions that do not forget. Parliament can underpin that by holding us to account in this endeavour, as it does on monetary policy – incentives matter in the official sector too. That will make for a safer and sounder financial system that can meet the abiding needs of the economy as a whole. And, to those of you here today, I would say that the Bank believes what it always believed: that sound and honest finance is not only essential for the economy, it will be good for the City too.”

Download the Full Speech

Source: Bank of England

The European Commission on Friday set a date of Sept. 11 to announce proposals to overhaul banking regulation in Europe, a crucial step in shoring up the euro zone against future crises

A new Pan-European regulatory system must be established before countries that use the euro can tap bailout funds to recapitalize their banks without taking on more sovereign debt, breaking the so-called doom loop in which frail banks can endanger national finances and push countries toward full bailouts.

Spain, which has won approval for a multibillion-euro recapitalization of its banks, has already indicated that it wants to receive euro bailout funds.

But European leaders, including Chancellor Angela Merkel of Germany, have made it clear that countries wishing to use bailout funds to recapitalize their banks directly will be able to do so only once there is better supervision and control of the banks that benefit from such rescues.

The commission, the European Union ’s executive body, was tasked with drafting the banking proposals after European leaders, at a meeting in June, committed to giving the European Central Bank a leading role in the new supervisory system.

To work properly, the new banking regulator will need far greater powers than the existing European Banking Authority, which is only about two years old. The banking authority lost credibility after it conducted two rounds of stress tests on European banks but failed to highlight the sector’s looming problems, particularly those in Spain.

In a statement, the commission said it would specify the central bank’s new role and its relationship with national supervisors. Putting the central bank in charge could greatly diminish the possibility of political interference in banking regulation by reducing the ability of countries to protect favored lenders.

It said it would also address whether banks outside the euro area would fall under the purview of the new system and to what extent the existing banking agency would maintain a supervisory role.

The commission said that its goal was to make the proposals on Sept. 11, but that the date was not final. It said the new system was to enter into force early in 2013, although analysts have said there may be delays.

One of the thorniest questions for the commission is how many banks the central bank will oversee, and whether they will include politically sensitive lenders like savings banks in Germany.

The proposed regulations will still be “subject to debate and agreement among the member states, and that is likely to prove contentious,” Mujtaba Rahman, an analyst for the Eurasia Group , wrote in a note on Thursday.

Because “many difficult issues remain,” Mr. Rahman wrote, “implementation could be delayed, in turn delaying the direct recapitalization of Spanish banks.”

Another important step toward shoring up the euro is the authorization of a permanent European bailout fund , the European Stability Mechanism, to succeed the current, temporary bailout fund, the European Financial Stability Facility. The permanent fund, capitalized at 500 billion euros, or $627 billion, was scheduled to begin operating over the summer but is now awaiting a decision on its legality by the German constitutional court, due on Sept. 12.

The delay in establishing the permanent fund is also holding up action by the European Central Bank to buy bonds from troubled euro countries in an effort to reduce borrowing costs and help the countries refinance their budgets. The central bank’s president, Mario Draghi, said this month that it was working on a bond-buying plan, but the bank is thought to be unwilling to proceed without the permanent bailout fund in place.

Source: New York Times

Americans who save for the future, use credit cards or borrow money for tuition, cars and homes

deserve assurance that the interest rates on their savings and loans are set in a reliable and honest way.

That’s why the revelation that the British bank Barclays attempted to manipulate the London interbank offered rate, or Libor — one of the benchmark rates used to determine the cost of borrowing around the world — is so disturbing. But the Barclays case isn’t only about misconduct by large financial institutions. It also raises questions about the reliability and accuracy of these key interest rates, which are largely determined by the private sector, without significant government oversight.

When you save money in a money market fund or short-term bond fund, or take out a mortgage or a small-business loan, the rate you receive or pay is often based, directly or indirectly, on Libor. It’s the reference rate for nearly half of adjustable-rate mortgages in the United States; for about 70 percent of the American futures market; and for a majority of the American swaps market, where businesses hedge risks from changes in interest rates.

Libor is supposed to be the average rate at which the largest banks honestly believe they can borrow from one another unsecured (that is, without posting collateral). Libor was set up in the 1980s when banks regularly made loans to other banks on that basis.

However, the number of banks willing to lend to one another on such terms has been sharply reduced because of economic turmoil, including the 2008 global financial crisis, the European debt crisis that began in 2010, and the downgrading of large banks’ credit ratings this year.

Banks have shifted toward secured borrowing and, on occasion, borrowing from central banks like the Federal Reserve and the European Central Bank. As Mervyn King, the governor of the Bank of England, said of Libor in 2008: “It is, in many ways, the rate at which banks do not lend to each other.”

These changes in the markets raise questions about the integrity of this important benchmark.

First, why is Libor so different from another benchmark interest rate for borrowing in United States dollars — Euribor, or euro interbank offered rate? Both rates are calculated on the basis of banks’ answers to roughly the same question. For Libor, a bank is asked at what rate it thinks it can borrow, while for Euribor, a bank is asked at what rate it thinks other banks are able to borrow. And yet the Euribor for dollar borrowings is about twice as high as the comparable Libor.

Second, why have Libor and other benchmark rates typically not been aligned, since 2008, with the borrowing rates that would be implied by foreign exchange markets? A long-established financial theory known as interest rate parity says that the difference in interest rates between two countries should be roughly in line with the expected change in exchange rates between the countries’ currencies. (If it isn’t, that opens an opportunity for arbitrage, the practice of taking advantage of price differences.)

Until 2007, as the theory predicted, the difference between the borrowing rate in one currency and the lending rate in another could typically be derived from foreign currency exchange rates. In the last few years, that hasn’t been the case, and this divergence between theory and practice has yet to be adequately explained.

Third, why is the volatility of the dollar -denominated Libor so much lower than the volatility of other short-term credit market rates? Just like stocks and bonds, short-term interest rates experience a certain volatility. But Libor has less severe swings than comparable rates.

In addition, the variation in rates that some banks submit to the British Bankers’ Association — the private group that oversees Libor — don’t seem to match the variation in the rates for their credit default swaps (financial instruments that are similar to insurance and are one measure of a bank’s credit risk). There have been times when the swap rates have widened for particular banks (suggesting a growing credit risk) even as their Libor submissions have remained stable (suggesting that the banks’ borrowing costs haven’t changed).

Anyone saving or borrowing for the future has a real stake in the integrity of Libor and in the answers to these questions.

When the Commodity Futures Trading Commission, which oversees derivatives markets, began looking into interest-rate setting in 2008, we were guided not only by questions about the decline of actual unsecured lending among banks, the supposed basis of Libor, but also by our founding statute, the Commodity Exchange Act. The law prohibits attempts to manipulate and falsely report information that tends to affect the price of a commodity — including interest rates like Libor.

Markets work best when benchmark rates are based on observable transactions. The public is shortchanged if Libor, the emperor of rates, is not clothed in such transactions.

One solution might be to use other benchmark rates — like the overnight index swaps rate, which is tied to the rate at which banks lend to one another overnight — that are based on real transactions. There are also benchmark rates based on actual short-term secured financings (loans in which collateral is pledged) between banks and other financial institutions.

For any new or revised benchmark to be broadly accepted by the financial markets, borrowers, lenders and hedgers who rely on Libor would benefit from a process for an orderly transition.

The Barclays case demonstrates that Libor has become more vulnerable to misconduct. It’s time for a new or revised benchmark — an emperor clothed in actual, observable market transactions — to restore the confidence of Americans that the rates at which they borrow and lend money are set honestly and transparently.

* Gary Gensler is the chairman of the Commodity Futures Trading Commission.

Source: New York Times

The Government is today publishing its response to the report by the Independent Commission on Banking (ICB), which sets out plans to fundamentally reform the structure of banking in the UK

This response agrees with the ICB’s recommendations and outlines how the Government will legislate to create a stable banking sector that supports lending to businesses and families, and removes the implicit taxpayer guarantee in the event of a bank failure.

The Government will implement the ICB’s advice in stages with the full package of reforms completed by 2019.  All necessary legislation will therefore be put in place by the end of this Parliament. The Government will publish a White Paper in spring 2012 setting out further detail on how the recommendations will be implemented; in advance of that, the Government is open to views on how to implement these plans.

The Chancellor of the Exchequer, the Rt Hon George Osborne, said:

“The Independent Commission on Banking was set up last year to look at what I have called the ‘British Dilemma’: how Britain can be home to one of the world’s leading financial centres without exposing British taxpayers to the massive costs of those banks failing.
The Government is preparing the most far reaching reforms of British banking in our modern history – our objective is to make sure what happened in Britain never happens again.”

The Secretary of State for Business, Innovation and Skills, the Rt Hon Dr Vince Cable, said:

“Sir John Vickers has produced a comprehensive plan to give the UK a more stable banking system that removes the implicit taxpayer subsidy.  We will take forward a full programme of reform with legislation in place to implement the ring-fence by 2015.

“The potential costs of an unsafe banking system are clear to everyone. Our reforms will protect taxpayers from the riskier aspects of banking and boost competition without harming the ability of UK banks to lend, to invest and to compete.”

Background
1. On 16 June 2010, the Chancellor of the Exchequer and the Secretary of State for Business announced the creation of the ICB, to be chaired by Sir John Vickers. The Commission was asked to consider structural and related non-structural reforms to the UK banking sector to promote financial stability and competition, and to make recommendations to the Government by the end of September 2011.
2. The ICB published its report on 12 September 2011, which can be found on the ICB website
3. In welcoming the report, the Government committed to responding by the end of 2011.  View the Government’s response.
4. Today’s response is open for comments until March 2012.

Executive Summary

In its final report the Independent Commission on Banking (ICB) made recommendations to promote financial stability and competition in UK banking. It recommended that its reforms be implemented no later than the start of 2019.

Financial stability

On financial stability, the ICB identified three key objectives:

• make banks better able to absorb losses;
• make it easier and less costly to sort out banks that still get into trouble; and
• curb incentives for excessive risk-taking.

The ICB recommended a package of measures, consisting of ring-fencing vital banking services and increasing banks’ loss-absorbency, to achieve these objectives. The Government strongly supports these objectives and this dual approach.

Ring-fencing

On structural reform, the ICB recommended ring-fencing vital banking services on which households and SMEs depend, keeping them separate from wholesale and investment banking activities. This would more effectively insulate them from problems elsewhere in the (global) financial system and make banks easier to resolve without taxpayer support. It would also curtail implicit government guarantees, reducing the risk to the public finances and making it less likely that banks will run excessive risks in the first place.

Improving resolvability of banks through structural reform is in keeping with international initiatives to make it easier to deal with failing banks. Structural complexity has been identified by the Financial Stability Board (FSB) as one of the most important barriers to successful bank resolution.  And a consultation document on a possible EU framework for bank recovery and resolution, published by the European Commission earlier this year , contemplated changes being required to the structure of financial institutions, so as to reduce complexity in order to allow critical functions to be separated off in resolution.

The Government agrees with the ICB’s recommendation that vital banking services – in particular, the taking of retail deposits – should only be provided by ‘ring-fenced banks’, and that these banks should be prohibited from undertaking certain investment banking activities. The Government agrees that structural reform of the banking sector is needed and supports the proposal for the creation of a ring-fence around vital banking services.

The ICB set out a number of principles on which the ring-fence should be based. For example the fence should be flexible in location but of sufficient height to ensure effective legal, operational and economic separation between entities. The Government supports all these principles. Specifically, the Government intends that:

• There be a set of mandated services within ring-fenced banks consisting of retail and SME deposits and overdrafts;
• A set of wholesale and investment banking services should be prohibited from the ring-fenced bank in order to meet the objectives of the policy;
• The ring-fenced bank should be allowed to conduct ancillary activities to support the provision of its core functions;
• The ring-fenced bank should be legally and operationally independent from the rest of its corporate group; and
• Economically the ring-fenced bank should not be dependent for its liquidity and solvency on the financial health of the rest of its group.

The ICB set out some further details to support these principles. For example ring-fenced banks should be regulated for capital and liquidity purposes on a solo basis, should not be over-reliant on the rest of the corporate group for funding and should undertake transactions with the rest of the group on a third party basis. There is further detailed work to be done to translate the principles into practice. More details on the ICB’s recommendations on structural reform, and the Government’s plans for taking them forward, are set out in Chapter 2. The ICB recognised that the case for de minimis exemptions to the ring-fence restrictions was finely balanced, but was not persuaded at the time. The Government’s view is that there is a case for reviewing whether a de minimis exemption should apply.

Loss-absorbency

On increased loss-absorbency, the ICB recommended higher equity requirements for large ring-fenced banks, a minimum leverage ratio, loss-absorbing debt, insured depositor preference and higher levels of loss-absorbing capacity for banks that are difficult to resolve.

Many of these recommendations also fall within the range of measures contemplated by internationally agreed reforms. The Basel III rules clearly set minimum, not maximum, standards for equity and leverage ratios. The FSB’s standards on resolution regimes require national jurisdictions to make debt loss-absorbing in resolution (‘bail-in’). And the European
Commission’s consultation document on a framework for bank recovery and resolution contemplates both bail-in and requiring institutions that are hard to resolve to hold more loss-absorbing debt.

The Government supports the ICB’s recommendations on loss-absorbency and sees these non-structural reforms as an important complement to ring-fencing in making banks better able to absorb losses, easier to resolve if they do fail, and in curbing excessive risk-taking. In particular:

• the Government intends to introduce higher equity requirements for large ring-fenced banks, and will seek sufficient flexibility in forthcoming European legislation to do so in the interests of UK and European financial stability;
• the Government strongly supports a mandatory, minimum leverage ratio for all banks, as recommended by the ICB, and believes there may be a case for applying a higher minimum leverage ratio to some larger banks;
• the Government agrees that the resolution authorities should have a statutory bail-in power to assist in bank resolution. The Government will seek to ensure agreement on including a robust bail-in power in the European crisis management framework;
• the Government supports the principle that systemically important banks hold a minimum amount of loss-absorbing capacity on a group-wide basis. However, if a bank can show that its non-UK operations do not pose a risk to UK financial stability and thus to the UK taxpayer, this requirement should not apply to those operations;
• on balance, the Government supports depositor preference, but believes that further analysis and consultation is needed on the scope of its application; andthe Government is of the view that supervisors should be able to require firms that are difficult to resolve to have additional loss-absorbing capacity.

More details on the ICB’s recommendations on loss-absorbency, and the Government’s response, are set out in Chapter 3 below.

The ICB’s financial stability recommendations have a clear focus on preserving the continuous provision of vital banking services located in the ring-fenced banks. However, it is important to draw a distinction between protecting the provision of critical services by ring-fenced banks, and protecting investors. Requiring ring-fenced banks to have more loss-absorbing capacity will ensure that the continuous provision of banking activities can be maintained, if necessary by imposing losses on investors – including creditors – not by guaranteeing them. The Government’s view is that all banks should be subject to normal competitive market forces, which means they must be able to fail safely without relying on a government guarantee and without putting the provision of critical services at risk.

The ICB’s proposals – by curbing incentives for excessive risk-taking, reducing the exposure of ring-fenced banks to the financial system and requiring non-ring-fenced banks to hold higher levels of loss-absorbing capacity – will also increase the resilience, and resolvability, of non-ringfenced banks. This is crucial. But in order to be effective, this will require the introduction of a resolution regime for all non-ring-fenced banks, including any that may not be covered by the Special Resolution Regime. The Government believes that all banks – including non-ring-fenced banks – need to be resolvable without the use of state resources, and believes the ICB’s proposals are an important step forward. But they should be complemented by the introduction of a resolution regime that covers investment firms and financial holding companies. This is discussed in Box 1.A.

Competition

On competition, the ICB made recommendations:

• to improve prospects for a strong and effective challenger to come out of the Lloyds divestiture;
• to mitigate barriers to entry and anti-competitive prudential requirements;
• to improve switching;
• to enhance transparency;
• to secure pro-competitive financial regulation; and
• on a possible future market investigation reference to the competition authorities.

The Government strongly supports all these objectives. A competitive banking sector is vital to ensure that the UK economy can benefit from banking products and services at efficient prices. Effective competition is also a spur to innovation and economic growth, and can lead to better quality and service for consumers. The emergence of a strong and effective challenger bank from the Lloyds divestiture – that would exert real, competitive pressure on the big banks – would be good for competition. A regulatory focus on improving competition is also consistent with strengthening the European single market – indeed the European Banking Authority and other European supervisory authorities are required to contribute to promoting “equal conditions of competition”.

The ICB’s recommendations on financial stability will also help to address competition concerns in financial services, and complement the competition recommendations. As the ICB noted in its final report, financial stability recommendations that eliminate the implicit government guarantee are themselves pro-competitive. Where banks are regarded as ‘too big to fail’, market participants – in particular debt investors – will contract with them on more favourable terms than with smaller banks, distorting competition. Therefore measures to tackle the implicit government guarantee will help to remove distortions in the European single market.

Going beyond the ICB’s recommendations, the Treasury Select Committee has called for the Payments Council, a private sector body responsible for setting the strategy for retail payment systems in the UK, to be brought within the scope of regulation. The Government supports this, and will consult in the New Year on options for enhancing the regulatory framework for payment systems.

More details on the ICB’s recommendations on competition, and the Government’s response, are set out in Chapter 4 below.

Economic impact and competitiveness

The ICB estimated that its package of recommendations would cost the banks £4bn-£7bn a year. The ICB said this could have a knock-on cost to GDP of around £1bn-£3bn a year, but this should be set against the benefits of reducing the annualised cost of financial crises of up to £40bn a year.

The ICB noted that the impact on the Government’s fiscal position of the reform package would be complex but should be strongly positive. However, the ICB did not attempt to quantify this. On competitiveness, the ICB noted that its recommendations would only affect around 15% of the banking institutions in the City and would not affect insurance companies, fund management firms etc. By improving financial stability the recommendations would in fact be likely to increase the attractiveness of the UK as a place to do both financial and non-financial business.

The Government has conducted its own economic impact analysis, informed by modelling exercises carried out by the major UK banks. On the basis of this work, the Government has concluded that while the ICB’s estimates do not capture the full range of costs, the measures that the ICB recommended will deliver net benefits to the UK economy and the taxpayer.

The Government estimates the aggregate private costs to UK banks at £3.5bn-£8bn. These additional bank costs are estimated to produce a gross reduction in GDP of £0.8bn-£1.8bn, somewhat lower than the ICB’s estimate. Against these costs should be set the potentially much larger benefits to the economy from increased financial stability. Based on the ICB’s estimate of the annual cost to the economy of financial crises, even if other regulatory reforms reduced the probability of a financial crisis by 30%, and the ICB’s recommendations reduced the probability of a crisis by only a further 10%, and the output loss caused by a crisis by 25%, the ICB’s recommendations would yield an incremental economic benefit of £9.5bn per annum. The Government therefore believes that the economic benefits of implementing the ICB’s recommendations would significantly outweigh the costs and will deliver significant net benefits to the economy and the public finances.

On competitiveness, the Government is committed to ensuring that the UK continues to be at the heart of the international banking and finance sector. This is best achieved by establishing a stable financial system in the UK, not by providing implicit taxpayer subsidies to a small proportion of the financial institutions that constitute the City.

More detail on these issues, including the Government’s own preliminary analysis of the economic impact and competitive effects of the ICB’s recommendations, is set out in Chapter 5.

Implementation

The ICB said that its recommendations should be fully in force by no later than the start of 2019, consistent with the deadline for implementation of the Basel III reforms agreed by G20 leaders. The Government’s intention is that implementation should proceed in stages with the final, non structural, changes related to loss absorbency fully completed by the beginning of 2019. Primary and secondary legislation related to the ring fence will be completed by the end of this Parliament in May 2015 and banks will be expected to be compliant as soon as practically possible thereafter. The Government will work with the banks to develop a reasonable transition timetable.

This response sets out the Government’s initial views on the ICB’s principal recommendations. The Government will bring forward a White Paper in Spring 2012 which will set out detailed proposals on the ICB’s recommendations, and launch a consultation.

Implementation of the recommendations will strengthen the European single market, as one of the biggest distortions to this market is the perceived implicit government guarantees. The ICB’s recommendations represent the UK’s contribution to removing these distortions. The
Government will work to ensure that current EU legislation does not hinder the reforms necessary to ensure financial stability and a sound financial system.

More detail on the proposed timeline and mechanics for implementation – and their interaction with the development of relevant European legislation – is set out in Chapter 6.

This response contains a number of outstanding policy questions. The responses to these will be used to inform the detailed proposals and further consultation that will be set out in the White Paper. Details on how to respond to the policy questions are set out in Chapter 6.

Get the The UK Government response to the Independent Commission on Banking and other documents.

The Financial Services Authority (FSA) has published its Board’s Report into ‘The failure of the Royal Bank of Scotland’ (RBS)

The Report concludes that RBS’s failure amid the systemic crisis ultimately resulted from poor decisions made by the RBS management and Board. But deficiencies in the global capital regime and liquidity regulations made the crisis much more likely. In addition, flaws in the FSA’s supervisory approach provided insufficient challenge to RBS.

Specifically, the Report concludes that the failure of RBS can be explained by a combination of six factors:

• significant weaknesses in RBS’s capital position, as a result of management decisions and permitted by an inadequate global regulatory capital framework;
• over-reliance on risky short-term wholesale funding, which was permitted by an inadequate approach to the regulation of liquidity;
• concerns and uncertainties about RBS’s underlying asset quality, which in turn was subject to little fundamental analysis by the FSA;
• substantial losses in credit trading activities, which eroded market confidence. Both RBS’s strategy and the FSA’s supervisory approach underestimated how bad losses associated with structured credit might be;
• the ABN AMRO acquisition, on which RBS proceeded without appropriate heed to the risks involved and with inadequate due diligence; and
• an overall systemic crisis in which the banks in worse relative positions were extremely vulnerable to failure. RBS was one such bank.

The multiple poor decisions that RBS made suggest, moreover, that there are likely to have been underlying deficiencies in RBS management, governance and culture which made it prone to make poor decisions. The Report, therefore concludes that these underlying deficiencies should be considered as a seventh key factor in explaining RBS’s failure.

FSA chairman, Adair Turner, said:

“People want to know why RBS failed and why no-one has been punished. This Report aims to answer those questions. It describes the errors of judgement and execution made by RBS executive management which, in combination, resulted in RBS being one of the banks which failed amid the global crisis. These were decisions for whose commercial consequences the RBS executive and Board were ultimately responsible.

“It describes, however, why the FSA’s Enforcement Division concluded that there was not sufficient evidence to bring enforcement action which has a reasonable chance of success in Tribunal or court proceedings.

“The Report also reinforces the conclusion that the global capital standards applied before the crisis were severely deficient and liquidity regulation was totally inadequate. Banks across the world, including RBS, were operating on levels of capital and liquidity that were far too low. These prudential regulations have been changed radically since the crisis, with the internationally agreed Basel III standards.

“Had Basel III been in place at the time, not only would RBS have been unable to launch the bid for ABN AMRO, but it would have been prevented from paying dividends at any time during the Review Period, i.e. from at least 2005 onwards.

“In addition, the Report concludes that the FSA was too focused on conduct regulation at the time and its prudential supervision of major banks was inadequate. The FSA operated a flawed supervisory approach which failed adequately to challenge the judgement and risk assessments of the management of RBS. This approach reflected widely held, but mistaken assumptions about the stability of financial systems and existed against a backdrop of political pressures for a ‘light touch’ regulatory regime.

“The Report describes a historic approach to supervision, and one that has been radically reformed since 2007. The FSA is a different organisation now. We have more resources, better skills, a more intensive approach and far greater focus on capital, liquidity and asset quality.

“The Government has decided to split the FSA and create two new regulators, a Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA). It has also established a Financial Policy Committee (FPC), with the responsibility to identify and respond to emerging systemic risks. The creation of the PRA, focused exclusively on prudential issues rather than spanning both prudential and conduct concerns, and of the FPC, will ensure that focus on prudential and systemic risks is maintained even when most of the world assumes, as it did before the crisis, that prudential risks are low.”

Many of the reforms required in response to the lessons highlighted in this Report have already been implemented. But in addition, Adair Turner proposed two key policy areas where further significant change should be considered. Firstly, he recommends that major bank acquisitions should in future, require explicit regulatory approval. And secondly, he calls for a public debate about changes to rules, laws or remuneration policies which would ensure that bank executives and directors face personal consequences as a result of bank failure.

Adair Turner concluded:

“The fact that no individual has been found legally responsible for the failure begs the question: if action cannot be taken under existing rules, should not the rules be changed for the future?

“In a market economy, companies take risks on behalf of shareholders and if they make mistakes, it is for shareholders to sanction the management and board by firing them.  But banks are different, because excessive risk-taking by banks, for instance through aggressive acquisitions, can result in bank failure, taxpayer losses, and wider economic harm.  Their failure is a public concern, not just a concern for shareholders.

“We should, therefore, debate policy options to ensure that bank executives and boards strike a different balance between risk and return than is acceptable in non-bank companies.  Two broad ways to achieve this could be considered:

1. A “strict liability” approach, making it more likely that a bank failure like RBS’s would be followed by successful enforcement actions, including fines and bans;
2. An automatic incentives-based approach involving either rules which automatically ban senior executives and directors of failed banks from future positions of responsibility, or major changes to remuneration to ensure that a very significant proportion of pay is deferred and forfeited in the event of failure.

“There are important pros and cons of these different ways forward, and complex and important legal issues which would need to be considered.  But by one means or another, there is a strong argument for new rules which ensure that bank executives and boards place greater weight on avoiding failure.  The options for achieving this merit careful public debate.  The FSA has committed to publishing a discussion paper on the options in the New Year.”

Notes

1. The original request for a report into why the FSA concluded no enforcement action could be taken was based around the content of three specific legal investigations. In these investigations, the FSA was assisted by PWC, and focused on the three specific areas of RBS’s activities deemed most likely to warrant the potential for successful enforcement cases against senior individuals within RBS. These three areas reviewed were:
   • issues relating to the expansion of RBS’s Global Banking and Markets Division and the conduct of its chairman;
   • the decisions made by RBS during the acquisition of ABN AMRO in 2007; and
   • the various investment circulars issued by RBS in connection with the acquisition of ABN AMRO, the Rights Issue of April 2008, and the open offer of November 2008.
2. 2 December 2010 announcement about the closure of the FSA investigation:
3. The FSA Board Report consists of three parts:
   Part One: ‘Why did RBS fail?’ which outlines the complex combination of factors which led to RBS’s failure.
   Part Two: ‘Lessons for the regulatory framework and supervision, and for the management of firms’, which analyses the causes of failure in more detail and seeks to identify:
   • the poor decisions made by RBS management and Board which made RBS highly vulnerable to failure, and the underlying aspects of RBS’s management style, governance and culture which may have contributed to those poor decisions;
   • any deficiencies in the overall regulatory framework, agreed largely at global level; which made systemic errors and therefore bank failures more likely; and
   • any flaws in the FSA’s supervision of banks in general and RBS in particular which resulted in insufficient challenge to RBS.

   Part Three:‘FSA enforcement’ which focuses on the three specific areas which were the subject of the FSA Enforcement Division’s investigations. It summarises the evidence considered in the course of those investigations and explains the reasons that led Enforcement Division to conclude that there were not grounds for bringing enforcement actions which had a reasonable chance of success.

Download the full Report into the failure of RBS

Speech: Lessons in lobbying by Robert Jenkins

Not long ago I was a lobbyist for the investment industry. I have now joined the ranks of the regulators I once tried to lobby. Specifically, I am a member of the interim Financial Policy Committee of the Bank of England. The “FPC” is the focal point for macro-prudential policy. The objective is to identify, and to the extent possible mitigate, threats to the UK financial system. At the moment, you might say our priority is to protect the banks from the financial system, and the financial system from the banks.

In a moment, I will have the honour to Chair the 3rd Gordon Midgley Memorial Debate. The topic is “short-termism” and our sponsor is a trade association. So before turning to the debate itself, allow me to pinch the podium to offer a few observations about short-termism (or more precisely short-sightedness) in lobbying. And for this, we need look no farther than the lobbying efforts of the banking industry in general and their campaign against banking reform in particular. Please note, that my remarks are my own.

Ladies and gentlemen, up to a point, it has been amusing to watch big banking’s fight against financial reform. Remember their first response to the crisis? It was to deny the very need for reform. How dumb was that? They quickly regrouped.

The next phase was to acknowledge that reform was necessary – but only if the rules could be agreed to globally. “Level playing field” was the rallying cry. “We will if they will.” This approach was less dumb – even clever. The lobby reasoned that global standards would be difficult to achieve and if achieved, would be set to the lowest common denominator of international consensus. The strategy was partially successful. The standards agreed were modest. Initial proposals were watered down. Best of all, the deadline for implementation was set for 2019 – a date so distant as to be irrelevant to any banker’s career and so extended as to be vulnerable to lots more lobbying.

But the champagne celebrations proved brief – because the markets accelerated the timetable. They have accelerated the timetable in two ways. First, the continued turmoil has reminded regulators of the need for banks to strengthen their balance sheets. Second, prospective bank creditors and shareholders have rediscovered risk adjusted returns and are now adjusting for the risks that banks have been taking and continue to take.

The banking lobby has responded by blaming Basel. Listen to the logic – albeit in my own words. “The Basel rules require safer banks. We were not supposed to have to be safer until 2019. Now because of you regulators, the markets want us to be safe now. To be safe now would require us to reduce our leverage. We can’t reduce our leverage by issuing equity because the markets are closed to new issuance. We can reduce leverage by curtailing intra-financial activity; or we can reduce leverage by reducing lending to the real economy. We will not do the former. We may well do the latter. If we do, it will be all your fault.”

In short the latest lobby tactic is to convince pundits, public and politicians that encouraging prudence too soon will hit the economy too hard. This is no longer amusing. This strategy is intellectually dishonest and potentially damaging.

It is dishonest because it is untrue. Politicians could abandon Basel altogether and it would not change the market view of many banks. What you would achieve is further erosion of confidence in the banking system. And it is potentially damaging because it promotes fear for an economy which the banks are there to serve and from which they draw their livelihood. For the truth is that banks can strengthen their balance sheets without harming the economy. They can do so by cutting bonuses, by curtailing intra-financial risk-taking and by raising term debt and equity. The markets are not closed to viable banks. Their executives are closed to the need to pay the price necessary to the raise the funds needed. For the sound, well run financial enterprise the money is there. It is just not there at yesterday’s price. Indeed it may well be that today’s prices discount to a large extent the need for more equity which the market requires and expects but which many bankers refuse to raise.

Thus a profession which should stand for integrity and prudence now supports a lobbying strategy that exploits misunderstanding and fear. I know that not all bankers agree with these tactics. They should stand up and distance themselves quickly. For in pursuing its short-sighted approach the banking lobby is unwittingly making the case for more intervention in an industry which refuses to reform.

As a former lobbyist I understand that lobbies are there to lobby; but I also know that leaders are there to lead. Bank lobbies are winning the battles and losing the war. As for bank leaders, they need to lobby less and lead a lot more.

And so ends our first lesson of the evening – a lesson in lobbying.

Source: Bank of England

Summary.

Policymakers need to be aware of the risk of extreme events such as recessions and banking crises. Given the future is uncertain, monetary policy makers need to consider the full range of risks around their forecasts when considering policy, including the probability of recession. Financial stability policy makers are by definition concerned with low probability events that could lead to banking crises.

The recent banking crisis and recession have raised the question of how closely the two events are linked, and whether a consideration of such interlinkages could have helped forecast these events better. There is a wide array of previous work that has considered ways to predict either banking crises or recessions; this paper considers whether estimating both together and allowing for interlinkages between the two events improves modelling performance.

Tests suggest there is evidence for correlation between banking crises and recessions, but this is the result of common observable causes rather than direct causal links. The probability that a country will be in recession is much higher in the year after a banking crisis than is normally the case. But, after accounting for external indicators, a bivariate probit model (which jointly estimates the probability of two correlated, separate discrete events) finds no evidence of correlation between banking crises and recessions. On the basis of previous work, this paper looks at an array of possible indicators of both banking crises and recession. Using a pooled sample of data since 1981 for fourteen advanced economies, including the United Kingdom, France, Germany and the United States, this paper finds that banking sector capital ratios, the deviation of the credit-to-GDP ratio from trend and the current account deficit are useful predictors of banking crises. The first principal component (a summary statistic of common trends in a selection of variables) derived from OECD leading indicators of GDP growth helps predict recessions, as do movements in real house and equity price inflation, and the current account deficit.

Like all forecasting models, the model presented here is prone to mistakes – tending to over-predict recessions and banking crises. In the period over which the model is estimated – 1981- 2005 – up to three-quarters of the model’s year-ahead predictions of recession were false alarms, while up to 90% of the predictions that a banking crises will occur were incorrect. The model’s out-of-sample performance (post-2005) is substantially better, but this indicates how unusual the past few years are, and is consistent with tests which suggest some model coefficients changed after 2005 (possibly reflecting the fact that increased global financial and trade inter-linkages increased the risk of banking crises and recessions in all countries through contagion).

Even though the precise model predictions are imperfect, the model does still provide policymakers with useful information. For example, the model points to the increased risk of a banking crisis in the United Kingdom in the mid-to-late 2000s and that this risk was higher than for many other advanced economies. The model also corroborates the risk of a contraction in 2009 but probably identifies it no earlier than did forecasters using existing techniques. It may therefore be a useful tool to include in the suite of indicators used by policymakers.

Download the full paper

Britain’s experiment with a new sort of bank regulation is sensible—and useful for the wider world

Like them or not, many of the most influential financial innovations of the past few decades have come from Britain: the euro-dollar market, the Private Finance Initiative and “light touch” regulation of financial firms. London cannot claim credit for having produced all of the whipping-boys of the financial crisis. Credit-default swaps and collateralised-debt obligations, to name but two, were proudly made in America. Yet London was the place where the world came to trade many of these instruments, making it the biggest hub for international banking and the pre-eminent laboratory of finance.

Now, with the release this week of a report by the Independent Commission on Banking (see post), whose recommendations the government says it will implement, Britain is conducting an experiment every bit as bold as its previous ones. The aim is to withdraw the long-standing public guarantees that buttress many of the world’s biggest banks without blowing up either the economy or the financial system.

The commission, chaired by Sir John Vickers, suggests splitting the country’s banks into two parts, dividing their retail- and commercial-banking bits from the racier investment and wholesale sorts. The retail bank will hold thick buffers of equity and loss-bearing debt that far exceed those agreed to internationally. The result will look more like the 1930s Glass-Steagall act in America than many British bankers had hoped.

That these bankers have not squealed louder partly reflects relief that regulatory uncertainty should now diminish. But it is also down to the commission’s success in drawing the sting of three potential objections. The first is that tougher rules risk making British banks less competitive. So the commission recommends higher standards only for the bits of the banking system that are rooted in the domestic market. Britain’s investment banks (principally Barclays Capital) will be held to the same equity capital standards as international peers.

The second objection is that there are diversification benefits to the universal-banking model. Stand-alone retail banks, such as Britain’s Northern Rock and America’s Wachovia, failed during the financial crisis, after all, when an investment-banking arm might have pulled them through. So the commission rules out a complete separation of the retail and wholesale businesses. The final critique is that adopting ring-fences and piling on more capital will drive up banks’ costs and may make credit more expensive in the wider British economy. But the transition periods are generous: banks have until 2019 to put the new structures in place, and lenders seem confident that they can get there without having to raise extra capital. And raising funding costs is partly the point of the exercise. By making it easier to dismantle a bank in trouble, the commission wants bank creditors to price in the potential for losses.

It is on the issue of failure, however, that the thornier questions still lie. The ring-fence structure makes a distinction between the bits of banking that need saving (deposit-taking banks, payment systems and the like) and the bits that do not (bonus-gorging investment bankers). But in a crisis it may not be possible simply to cut investment banks loose. The destruction wrought by the Lehman bankruptcy is exhibit A. Ask yourself, too, whether euro-zone politicians would want any big bank to go under right now. The Vickers answer is to get banks also to hold thick layers of “bail-in” debt that will impose losses on private creditors of a failing institution before taxpayers are called into action. A fine idea, but these instruments are in their infancy and have yet to be tested.

The petri-dish of finance

If the Vickers proposals do not guarantee an end to the crises that periodically plague finance, they still represent a worthwhile attempt to disentangle the hold that banks exercise over the public purse. Other countries are under less pressure to experiment: Britain has an outsize banking system that verges on being too big to save, let alone too big to fail. But the financial world should once again be keeping its eyes on London.

Source: The Economist