Select Committee on Treasury Fifth Report

8  Reforms

Introduction

300. We have concluded in the previous chapters that three sets of additional powers are required by the regulatory authorities: those related to 'prompt corrective action', the special insolvency regime for banks, and the change of rules around deposit protection. In this section, we deal with how modifications to the Tripartite structure will be required to enable the authorities to operate these new powers.

The Deposit Protection Fund

301. We have already recommended that deposit protection should be pre-funded. This pre-funding will lead to the creation of a Deposit Protection Fund. The creation of such a fund will act as a visible reminder to depositors of the safety of their insured deposits. Because of the need for consumer confidence in the Fund, the location of the fund within the Tripartite structure, or in a new institution, places upon that institution certain responsibilities. In essence, the institution in charge of the Fund would have a responsibility which may be summarised as protecting the Fund. This responsibility will lead to duties for identifying weak financial institutions, failings in the regulatory system, or systemic threats to banks where they are vulnerable to the macroeconomic or overall financial environment.

302. It is obvious from the evidence we have received that the Financial Services Compensation Scheme (FSCS) as it stands is in no position to assist with the failure of a large deposit-taking financial institution. However, it has coped well with the collapse of smaller institutions, such as credit unions. It also engages with insurers, mortgage advisers and Independent Financial Advisors. The Financial Services Compensation Scheme model works well for all institutions other than large deposit-taking institutions, where systemic risk is more prevalent. We therefore recommend that the Financial Services Compensation Scheme continue to operate under its current regime for all institutions other than large deposit-taking institutions. We also recommend that the authority in charge of the Deposit Protection Fund decide on how such large institutions should be selected. However, in order to prevent discrepancy in the market, we recommend that the insured deposit limit for individuals under the continuing Financial Services Compensation Scheme be equal to that under the Deposit Protection Fund.

Regulatory powers

303. We have already discussed in Chapter 5 the additional regulatory powers required for 'prompt corrective action' and in dealing with bank insolvencies. The question then arises as to where within the regulatory system such powers should reside.

304. In our visit to the United States, we learnt that occasionally a failing bank would raise its interest rates to encourage further deposits at that institution, in the hope that such deposits would see it through its period of weakness. Consumers continued to invest with that bank, sometimes despite knowing it might fail, because of the deposit insurance provided by the FDIC. The regulatory authorities in the United States therefore have the power, under certain circumstances, to restrict or prevent banks from accepting new deposits to prevent such abuse of the deposit insurance scheme. This is one example of the necessity of the new regulatory powers that would be required to protect the operation of the Deposit Protection Fund. We therefore recommend that the new regulatory powers relating to banks set out in Chapter 5 of this Report reside with the institution that also controls the Deposit Protection Fund.

305. We have already concluded that we do not wish to dismantle the current structure of the Tripartite system. We therefore do not support the creation of a new institution similar to the US Federal Deposit Insurance Corporation.

Quis custodiet ipsos custodes?

306. We have concluded that one of the responsibilities of the holder of the Deposit Protection Fund will be to identify regulatory failings that might affect the Fund. One of the elements of the United States regulatory system frequently mentioned to us during our visit as important was 'creative tension'. The organic growth of the United States regulatory system has led to multiple regulatory agencies with overlapping responsibilities. This overlap, while at a cost of potential duplication of work for financial institutions, has also meant that regulatory authorities have challenged each other over their regulatory decisions and outlook. Regulators in the United States impressed upon us the benefit of having other regulators questioning their work. This 'creative tension' between regulators was felt to play an important part in ensuring a more dynamic regulatory environment.

307. Placing the proposed new regulatory powers with the Financial Services Authority would benefit from the synergies of being held by the current regulator. However, such a move would reduce the capability for 'creative tension' within the regulatory system. As well as this, there are several other potential conflicts of interest for the Financial Services Authority if it were to assume the additional powers and responsibilities. In such circumstances, a conflict would arise between the role of the Financial Services Authority as regulator and its new role enforcing action on a financial institution that might be in trouble as a result of lax regulation. The second is the conflict between the current requirement under the Memorandum of Understanding of the Financial Services Authority to act to try and find a private sector solution for a failing financial institution, and also be the regulator of the receiving financial institution. Thus, by trying to protect the depositors of one institution, it might place at risk the depositors and shareholders of another by promoting or facilitating a private sector solution.

308. We consider the need for 'creative tension' within the regulatory system as of sufficient importance to justify overlooking any possible synergies of co-locating the new powers recommended in this Report alongside the existing powers of the Financial Services Authority. We have concluded it would be inappropriate for the Financial Service Authority to receive the Deposit Protection Fund, or the associated additional powers. As such, this leaves the Treasury and the Bank of England as the remaining candidates for receiving the Depositor Protection Fund and those powers.

The limits of political control

309. We have already concluded that there is a need for banks to be allowed to 'fail' so as to preserve market discipline. But they must do so in an orderly manner. One of the other lessons that was emphasised to us in the United States was the potential over-emphasis of politicians on the need to save banks because of political concerns, rather than from an appraisal of the underlying economic arguments of whether a firm should fail. To counter this threat in the United States, the Federal Deposit Insurance Corporation Improvement Act 1991 [FDICIA] contained the 'systemic risk exception', which restricted the ability of policy-makers to override the 'least-cost' to the taxpayer requirement for bank resolution discussed in Chapter 5. Ms Bair, Chairman of the Federal Deposit Insurance Corporation in a speech in Washington DC, explained how the onerous requirements for the use of 'systemic risk exception' curtailed the Federal Deposit Insurance Corporation's support for preventing losses above the insured amounts:

The systemic risk provisions of FDICIA also significantly raised the bar for policy-makers inclined to favour short-term stability. According to FDICIA, safety net protections can be extended beyond insured depositors only if it can be determined that not doing so would 'have serious adverse effects on economic conditions and financial stability.' To invoke the systemic risk exception, FDICIA requires a two-thirds majority of both the Boards of the FDIC and the Federal Reserve, as well as the approval of the Secretary of the Treasury, who must first consult with the President. In addition, the banking industry must pay for the additional cost associated with a resolution pursuant to a systemic risk finding through a special assessment. Because the special assessment is to be proportional to each bank's liabilities, large banks will bear the greatest burden of paying for the extension of the safety net.[579]

As well as this, we have already concluded [in Cross reference] that support operations will be only enacted 'as a last resort'. This will further reduce the need for the Treasury to be involved with decisions relating to failing banks.

310. It is right that where taxpayers' money is being used in a support operation, there should be political responsibility, and that the Chancellor of the Exchequer should make the final decision on whether such operations should be conducted. However, in most instances, regulatory action should and will be taken before such "last resort" support is required. This would be the benefit of a "prompt corrective action" approach. As such, we see no reason for the Chancellor of the Exchequer to be primarily responsible in the decisions that do not require taxpayer support. We have therefore concluded that it would be inappropriate for that the Treasury be the location for the Deposit Protection Fund.

Allocation of the new powers and their relationship to existing responsibilities of the Bank of England

311. The Bank of England is therefore a potential recipient of responsibility for the additional powers in relation to banks in distress that we proposed in chapter 5 and for the Deposit Protection Fund that we proposed in chapter 6. In relation to the powers under chapter 5, allocation of these responsibilities to the Bank of England would complement the Bank's existing oversight of liquidity and its money market operations, and would strengthen the involvement of the Bank with the liquidity of individual banks. In relation to the powers under chapter 6, attribution to the Bank of England would make sense given that the Bank of England has experience in handling pools of assets of the kind that would be built up by the Deposit Protection Fund, such as the Cash Ratio Deposit Scheme. Overall, the new powers would dovetail with the existing responsibilities of the Bank of England in relation to financial stability, while at the same time ensuring the 'creative tension' that we earlier said that we wished to see in the regulatory system. Such a change would also respond to the concern of the BBA that downplaying the role of the Bank of England would not be regarded well by the international community.[580]

312. However, we consider that reform of the management structure of the Bank of England will be required in order for the new powers to be carved out effectively within the Bank of England. Such reform will be necessary to ensure that proper weight is given to the increased responsibilities within the management structure, while also maintaining the appropriate priority for the conduct of monetary policy. The events of August and September 2007 have highlighted the need for a Chancellor of the Exchequer to receive authoritative and co-ordinated advice in any future case where financial stability is threatened by difficulties in the banking sector. The reforms must therefore be implemented in a manner that ensures that advice can be given which reflects a full understanding of information available within the FSA and the perspective of the FSA as well as that of the Bank of England.

313. There is also a need to protect the independence of the Monetary Policy Committee of the Bank of England. Professor Buiter highlighted this problem when discussing whether support operations should be conducted by the Bank of England:

The market support will always have to be done by the Bank of England, and you may therefore wish to put the individual institution support there as well. I think there are tensions there with central bank independence because especially individual institution-specific support operations are always deeply and inherently political (with a very small "p") because property rights are at stake and it is difficult to have that done by the same institution that is meant to be non-political. If you were to give banking supervision and regulation, including the lender of last resort knowledge therefore, back to the Bank of England, then you might want to take the MPC out of the Bank of England.[581]

Professor Buiter also noted the need for the Monetary Policy Committee to achieve its policy rate by undertaking operations in the money markets. Such operations will remain in the purview of the Monetary Policy Committee, but the same would not apply to other money market operations.

314. We do not consider that it would be appropriate for the Governor of the Bank of England to assume direct responsibility for the exercise of the new powers that we have proposed in chapters 5 and 6 relating to handling failing banks and the new Deposit Protection Fund. We envisage that the exercise of the new powers should rest first and foremost with a person who should have full-time responsibility for that exercise. We are also not convinced that direct responsibility for the new powers by the Governor of the Bank of England is appropriate in view of the Governor of the Bank of England's duties as Chairman of the Monetary Policy Committee.

315. We recommend the establishment of a new post of "Deputy Governor of the Bank of England and Head of Financial Stability". He or she will have direct responsibility for the exercise of the new powers we have proposed in Chapter 5 and for the Deposit Protection Fund. The holder of the new post should have full authority within the Financial Services Authority to meet the requirements of his or her post. We recommend that paragraph 1(2) of Schedule 1 to the Bank of England Act 1998 be amended so that the Deputy Governor and Head of Financial Stability would not be required to work exclusively for the Bank of England. The holder of this new post will have a key role in ensuring that a Chancellor of the Exchequer receives authoritative and co-ordinated advice in any future case where financial stability is threatened by difficulties in the banking sector, and that post-holder would be one of the principal channels of advice to the Chancellor of the Exchequer.

316. An extension of the responsibilities of the Bank of England in the manner we have recommended and the creation of the post of Deputy Governor and Head of Financial Stability must be accompanied by a review of the management structure and lines of responsibility within the Bank of England to ensure that:

• the Governor of the Bank of England's authority and leadership within the new structure of the Bank of England remains clear; and
• there is an appropriate division of management and other responsibilities between the holder of the new post and the other Deputy Governor of the Bank of England.

We recommend that, as part of this review, consideration be given as to whether it would be appropriate for the holder of the post of Deputy Governor and Head of Financial Stability to be a member of the Monetary Policy Committee or whether that position should be assumed by a senior member of Bank of England staff specifically charged with responsibility for the interface between financial stability and monetary policy. We recommend that the Deputy Governor and Head of Financial Stability have an important role in the Bank of England's money market operations, but work will be needed to clarify the distinction between that role, and the role needed to ensure money market operations to enact monetary policy.

317. We recommend that an Office of the Deputy Governor and Head of Financial Stability be created within the Bank of England, including staff seconded from the Financial Services Authority, HM Treasury and other organisations.

Responsibilities of the Office of the Deputy Governor and Head of Financial Stability

Horizon scanning

318. The Office must develop a forward-looking analysis, attempting to identify trends and potential risks to the financial system, and provide a regular update on those risks for the financial community. This role would also include adapting and improving stress-testing techniques, both at the system and individual institution level.

Ensuring that warnings are heeded

319. One aspect of the recent crisis is the apparent lack of attention paid by financial institutions to the warnings of the Financial Services Authority and the Bank of England. The Office of the Deputy Governor and Head of Financial Stability should be charged with ensuring a feedback system is incorporated between financial institutions and the regulatory authorities for issues relating to financial stability. This feedback system will not just be limited to the financial institutions that have absorbed the message, but also whether the Financial Services Authority has taken these messages onboard. This would of course be linked to the horizon scanning function we outline above. We will discuss this further in our Report on Financial Stability and Transparency.

UNDERTAKING ANALYSIS AND REGULATORY ACTION TO PROTECT THE DEPOSITOR PROTECTION FUND

320. To protect the Deposit Protection Fund for which it would be responsible, the Office of the Deputy Governor and Head of Financial Stability would identify outlying, weakened or potentially systemic financial institutions, and ensure that 'prompt corrective action', if needed, is undertaken. In more extreme circumstances, the Office would have the power to place an institution in the special resolution regime. Such a role would, of course, see this Office working closely with the Financial Services Authority, and we would expect full information disclosure between the Office and the Financial Services Authority. The expectation would be that, while the Office of the Deputy Governor and Head of Financial Stability would have the power to send inspectors into financial institutions covered by the Deposit Protection Fund and to those to which it is considering extending its protection, it would in the main rely on information provided by the Financial Services Authority, marrying this information with the information the Bank of England also receives via its operations in money markets, and liaison work conducted by the Office.

CRISIS MANAGEMENT UNIT

321. We have already concluded that the communications strategy for handling the September 2007 crisis was weak. We therefore recommend that the Office of the Deputy Governor and Head of Financial Stability be given lead responsibility within the Tripartite authorities on ways to ensure that there is clear, coherent and effective communications with the public and the markets in any future financial stability crisis.

322. We recommend, given the potential for a conflict of interest between different functions of the Financial Services Authority, that the Deputy Governor and Office of the Head of Financial Stability be given the role of leading for the Tripartite authorities in relation to the identification of third-party buyers for stricken firms.

323. We recommend that the Office of the Deputy Governor and Head of Financial Stability be given the role of identifying and managing the relationship of the Tripartite authorities with third-party private sector assistance.

LEGISLATIVE REFORM

324. One of the lessons learnt from this crisis is that legislation had been in preparation before the crisis hit; but that preparation process was not well-advanced. We recommend that the Office be responsible for identifying weaknesses in the legislative framework for financial stability and crisis management and liaising with the Treasury on the formulation of appropriate legislative responses.

325. To prevent an overburdening of the Deputy Governor and Head of Financial Stability, we recommend consideration be given to the case for each of the tasks outlined above to be assigned to a separate Director within the Office of the Deputy Governor and Head of Financial Stability to be charged with overseeing each task.

REPORTING AND ACCOUNTABILITY

326. We recommend that, in addition to being responsible for the Bank of England's Financial Stability Report, the Office of the Deputy Governor and Head of Financial Stability produce an annual report on its activities and the work of the Tripartite Standing Committee.

CHARACTERISTICS OF THE HEAD OF FINANCIAL STABILITY

327. As the focal point for most work to be conducted on financial stability, the 'Deputy Governor and Head of Financial Stability' will require certain attributes. Some of these attributes will relate to the work he or she might have to undertake in a crisis, others to his or her role as one of the principle channels of advice to the Chancellor of the Exchequer. We recommend that the Deputy Governor and Head of Financial Stability should have credibility in the financial markets.

Any appointee to this new post would be the subject of a pre-appointment hearing with this Committee.

Operation of the Tripartite arrangements under the new structure

328. We recommend that there should be at least one meeting of the Tripartite standing committee at the Principal level every six months. We would expect a Chancellor of the Exchequer to ensure that, in any case where financial stability is threatened, he or she would be able to draw directly upon the experience and advice of the Deputy Governor and Head of Financial Stability as well upon that of the Governor of the Bank of England and the Chairman of the FSA.

329. We recommend that formal advice given to the Chancellor of the Exchequer by the other Tripartite authorities in any future circumstances where financial stability is threatened be published as soon as reasonable after the immediate threat has passed, excluding any commercially sensitive information.

Responsibilities of the Treasury

330. The Treasury normally deploys approximately 65 staff to work on financial services, as well as allocating 50% of the department's legal resource to that team. Sixteen of those 65 staff would normally work in the Financial Stability and Risk team. By October 2007, 15 additional staff had been temporarily allocated to work on these issues.[582]

331. We have already recommended that the Head of Financial Stability be the principal adviser to the Chancellor of the Exchequer on Financial Stability issues. The proposals in this chapter should help to ensure that, in future crises, a Chancellor of the Exchequer receives clear, consistent and authoritative advice. We believe that the reforms outlined in this chapter will reduce the reliance on the Treasury's own resources in future crises. Nevertheless, it is the responsibility of all Chancellors of the Exchequer to satisfy themselves that they and their ministerial team are fully prepared for the roles they could be called upon to play in a future period of financial instability.

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579   Remarks by Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation at the Exchequer Club; Washington, DC on March 21, 2007 Back

580   Ev 295 Back

581   Q 866 Back

582   Memorandum from the HM Treasury,  Back

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Prepared 26 January 2008