Select Committee on Treasury Written Evidence


Memorandum from the London Investment Banking Association

  1.  We are writing in response to the invitation of the Treasury Committee to submit written evidence in respect of the Committee's inquiry into Financial Stability and Transparency. LIBA is the trade association for investment banks with operations in London. Its objective is to ensure that London continues to be an attractive location for the conduct of international investment banking business. A list of our members is attached (and is also available on our website: www.liba.org.uk).

  2.  Fresh information in relation to the events being examined by the Committee continues to emerge and we expect that this will remain the case for some time to come. Our thoughts are, therefore, necessarily only preliminary. We should add that we are seeking primarily to highlight points where further information or enquiry is needed before any conclusions can be drawn.

EXECUTIVE SUMMARY

  3.  In this submission, we comment on those issues identified in the invitation which are of particular relevance to our members, and on those with more general implications. These include:

    (a)  The functioning of the Tripartite system and lessons for Lender of Last Resort operations;

    Criticism has been levelled at the very separation of responsibilities, with some arguing that it was itself a contributor to uncertainty. But consideration needs to be given to whether or not any alternative set of arrangements would have led to a different outcome, before any potential changes to the arrangements can be properly assessed.

    (b)  Possible modifications to the insolvency regime for deposit taking institutions, including shareholder notification requirements, transparency requirements, the Takeover Code and the Market Abuse Directive;

    On the question of whether bank depositors should be in a special position when compared to other creditors of an insolvent institution and the question whether "core banking functions" (however defined) should be preserved when an institution fails, we are considering the issues with our members and will respond in due course to HM Treasury's discussion paper "Banking reform—protecting depositors" dated 11 October 2007.

    It has been suggested that the interplay of the various legal requirements which bear on transfers of shareholdings impose restrictions on the ability of the authorities to carry out a restructuring of a financial institution, without precipitating the very crisis which that restructuring is intended to avoid. It is clearly desirable that, if the measures concerned, in combination, have this effect, appropriate modifications should be made, including at European level if that proves necessary.

    (c)  Changes that may be required to the regulatory requirements regarding liquidity;

    Work at regulatory level and by the industry needs to be carried out carefully and thoughtfully. It would be easy to carry out a wrong analysis and draw a conclusion that could be damaging to firms' ability to manage their own liquidity needs effectively and securely. We think that liquidity risk management warrants further attention and we support the efforts that are already in train.

    (d)  Any other regulatory changes that may be required;

    At this stage, we would discourage hasty legislative intervention because:

    (i)  The dimensions of the problem are not yet known;

    (ii)  There are good grounds for believing that the wholesale market is beginning to correct itself; and

    (iii)  Further work is under way in a variety of groups, considering a range of questions. In particular, we would single out international regulatory efforts in relation to securitisation practices, disclosure and valuation.

    (e)  The implications of any wide-ranging modifications to the operation of the Financial Services Compensation Scheme's deposit sub-scheme;

    Minimum levels of compensation coverage are prescribed under the EU deposit guarantee and investor compensation directives. The home country basis on which these directives apply means that non-UK EU firms cannot be required to contribute to FSCS compensation payments made to UK customers. There is a question of competitiveness for the UK, therefore, which should not be lost sight of when changes to FSCS financing arrangements are discussed. We, with our Members, are examining the issues that the Tripartite authorities have raised in the consultative document, so we cannot comment definitively at this stage. To the extent that the FSCS is supposed to have some behavioural impact, it is clear that the level of confidence it provided proved inadequate during the events in September. It is not clear however what the position would have been with the more generous cover now available. It is also important to avoid arrangements that could lead to the kind of costs borne by taxpayers following the losses of US Savings and Loans depositors in 1986-95. In order to address moral hazard issues, in reviewing the UK scheme it will be necessary to consider arrangements that address the risk of depositors simply opting for accounts paying the highest rate of interest.

    (f)  More general questions about the overall functioning of financial markets.

    Our view, briefly stated, is that shortcomings in the US relating to certain classes of asset backed securities led to uncertainty and loss of confidence in valuations more widely. That uncertainty, in turn, led investors to seek to unwind their positions in securities they perceived to be affected; this rational response led, in turn, to illiquid market conditions in a number of markets. As we explain, the present position is correctly summarised, in our view, by the Financial Stability Forum.

    The ability of investment institutions to borrow money with which to acquire financial instruments of a stated credit quality is likely to be more relevant to a discussion of the operation of financial markets than the trend to more leveraged issuers—including the acquisition of quoted companies by private equity groups willing to take more risk with the corporate finance structure. We do not believe that this trend has had particular adverse effects on the markets for financial instruments secured on other assets.

  4.  We are working with our colleagues in similar organisations around the world to co-ordinate the industry's response to recent events and to contribute to international work by the industry and the regulators.

THE FUNCTIONING OF THE TRIPARTITE SYSTEM AND LESSONS FOR LENDER OF LAST RESORT OPERATIONS

  5.  At this stage, we do not think it is appropriate to comment in detail on the operation of the Tripartite arrangements.

  6.  The Tripartite arrangements necessarily separate the responsibilities of the Treasury (overall responsibility for legislation and accessible to Parliament), the Bank (financial stability), and the Financial Services Authority (supervision), in relation to financial markets and institutions. The separation is intended to clarify the roles each body should play both in normal market circumstances, and in the event of a crisis. At this stage it is not clear whether the arrangements themselves worked as intended during the period leading up to the Government's decision to stand behind Northern Rock, whether there were particular issues on the communications front or whether the arrangements were intrinsically defective in some way. Criticism has been levelled at the very separation of responsibilities, with some arguing that it was itself a contributor to uncertainty. But consideration needs to be given to whether or not any alternative set of arrangements would have led to a different outcome, before any potential changes to the arrangements can be properly assessed.

  7.  The justification for Lender of Last Resort (LOLR) operations, in the final analysis, rests in the special role that banks have in the financial system. Because there are clear externalities involved, banks can—in certain circumstances—look to the authorities for support in a way in which other commercial organisations cannot. LOLR action is traditionally justified in circumstances where the institution concerned is "systemically significant". There are good reasons for the authorities to maintain some imprecision over how this term is applied in practice. What the Northern Rock case brings out is that, in assessing systemic significance, it is necessary not only to consider the institution itself but also knock-on effects on other institutions, within the system.

  8.  It is worth noting that there is a conceptual distinction between the framework for the Bank's operations in the sterling money markets—which, while they can be modified so as to provide additional central bank liquidity against a wider range of collateral, or over longer periods, in order to reduce market interest rates at longer maturity, are directed at the market as a whole—and the LOLR arrangements provided for in the MOU, which relate to individual institutions and can potentially involve a greater degree of flexibility. There is a balance to be struck between the requirements of these two regimes.

POSSIBLE MODIFICATIONS TO THE INSOLVENCY REGIME FOR DEPOSIT TAKING INSTITUTIONS, INCLUDING SHAREHOLDER NOTIFICATION REQUIREMENTS, TRANSPARENCY REQUIREMENTS, THE TAKEOVER CODE AND THE MARKET ABUSE DIRECTIVE

  9.  There are two areas where a policy review of the insolvency arrangements is already underway. These are the question of whether bank depositors should be in a special position when compared to other creditors of an insolvent institution and the question whether "core banking functions" (however defined) should be preserved when an institution fails. The tripartite discussion paper issued jointly by HM Treasury, the Bank of England and the FSA "Banking reform—protecting depositors" dated 11 October 2007 discusses both. As noted the section below, headed "Modifications to the operation of the Financial Services Compensation Scheme's deposit sub-scheme", we are considering the issues with our members and will respond to the Tripartite authorities' paper in due course.

  10.  At European level, the Credit Institutions Winding Up Directive[8] ("WUD") has been designed to indicate which insolvency regime will apply to a bank with operations in more than one EU member state. Aspects of the operation of the WUD are currently under review. Any change to UK law will need to take account of the effect of WUD and any changes to it as these emerge.

  11.  It has been suggested that the interplay of the various legal requirements which bear on transfers of shareholdings impose restrictions on the ability of the authorities to carry out a restructuring of a financial institution, without precipitating the very crisis which that restructuring is intended to avoid. It is clearly desirable that, if the measures concerned, in combination, have this effect, appropriate modifications should be made, including at European level if that proves necessary.

CHANGES THAT MAY BE REQUIRED TO THE REGULATORY REQUIREMENTS REGARDING LIQUIDITY

  12.  Liquidity risk is one of the primary risks that financial institutions face. Liquidity risk for a firm is the risk that it will be unable to meet its obligations as they come due because of an inability to liquidate assets (or to obtain adequate funding—this is referred to as "funding liquidity risk"). There are two ways in which this risk is manifested: the illiquidity of the individual firm and the illiquidity of the markets. In this section we refer primarily to the liquidity of financial institutions and the need for this risk to be carefully managed.

  13.  A firm's liquidity is measured by its cash reserves and its ability to realise its assets for cash. Market liquidity refers to the extent to which assets in a particular market can be readily traded without adversely affecting the price. When liquidity dries up in a market, then firms' ability to realise assets for cash is restricted and the firm's own individual liquidity will be reduced and its ability to meet its commitments may be impaired.

  14.  The Basel capital adequacy framework is a framework for the solvency of a financial institution, seeking to ensure firms will have sufficient capital reserves to withstand a degree of loss due to impairment of value or defaults on their assets. Capital adequacy regulation does not address—nor is it intended to address—the liquidity of an institution. Unlike capital adequacy, liquidity is not regulated on a harmonised basis at the European level but national requirements exist. These requirements focus primarily on seeking to ensure that individual institutions maintain a stock of assets that are under normal circumstances highly liquid—or have access to such assets. Both solvency and liquidity regimes stress the need for firms to carry out scenario and contingency planning in relation to extreme conditions.

  15.  Regulators have been well aware for some time of the importance of liquidity regulation and there have been both regulatory and industry initiatives at international level as well as the national level in recent years. This work notably includes the issue by the Joint Forum (the Committee on which banking, securities and insurance regulators sit) of key principles for liquidity risk management. The current work of the Basel Committee builds on this contribution. On the industry side, the International Institute of Finance (IIF) issued, in March 2007, "Principles of Liquidity Risk Management". Within the UK, industry associations (including LIBA, the British Bankers' Association (BBA) and the International Swaps and Derivatives Association (ISDA)) are cooperating to analyse further how to develop such work.

  16.  Work at regulatory level and by the industry needs to be carried out carefully and thoughtfully. It would be easy to carry out a wrong analysis and draw a conclusion that could be damaging to firms' ability to manage their own liquidity needs effectively and securely. We think that liquidity risk management warrants further attention and we support the efforts that are already in train.

  17.  We wish to draw particular attention to the following features of liquidity risk management that should be borne in mind in creating any new regulatory regime that applies either at international or at national level.

  18.  "One size does not fit all". This point is true for many areas of regulation and especially so for liquidity, where the liquidity needs and risks of a firm can reflect the different structures of business that may be in place. In the EU dimension, the same regulation frequently applies to banks and to investment firms; however the balance sheet structures (ie the funding and asset profiles) can differ significantly between the two and expose these firms to different types of risk. Quality of liquidity risk management and control must be high in both sectors, but the precise methods may legitimately differ and in some cases it will be essential that they differ.

  19.  When managing liquidity risk, international groups,—whether global or European and whether banking groups or securities groups—must also take account of the extent to which local regulations will impede or facilitate the group's ability to direct funds to where they are needed among the members of the group. Therefore it is essential for regulators to weigh carefully how to take account of the cross border dimension and ensure that obstacles are not put in the way of a group's ability to manage risk effectively or to support subsidiaries or branches when this might be necessary.

  20.  We take comfort from the fact that regulators have been willing to pay close attention to the IIF work on liquidity management principles which we support and which associations in the UK (including LIBA, ISDA and the BBA) are seeking to assess and as necessary develop further in local conditions. We think this is a fruitful direction for work at the G10 and also the EU level, where the EU is presently monitoring the work of the G10. We support this approach.

  21.  However, we are also conscious that the Basel Committee focuses on banking regulation. If proposals for regulation are put forward that go beyond issues of risk management, then it is imperative that there is an assessment of the needs of investment firms. The FSA, in our view, is fully aware of this need but it will be important to ensure that this dimension is taken into full account if there is a possibility of new EU legislation applying to banks and investment firms. Both the FSA and HM Treasury will need to be proactive in any EU negotiation.

  22.  In conclusion, we support initiatives that focus on liquidity risk management principles. We endorse the call for more work to analyse how liquidity risk models have fared in the recent events, and to assess the cross border dimensions. We support the temperate approach that regulators have taken so far and stress the need to ensure that any new proposals are fit for purpose not only for banks but for investment firms.

ANY OTHER REGULATORY CHANGES THAT MAY BE REQUIRED

  23.  It seems reasonable to expect that institutional investors will insist on improved contractual terms and much greater transparency of the underlying assets. At this stage, therefore, we would discourage hasty legislative intervention because:

    (a)  the dimensions of the problem are not yet known;

    (b)  there are good grounds for believing that the wholesale market is beginning to correct itself; and

    (c)  Further work is under way in a variety of groups, considering a range of questions. In particular, we would single out international regulatory efforts in relation to securitisation practices, disclosure and valuation. We refer to some of these in "International work" below.

  24.  We also caution against taking precipitate regulatory action. There is still much to be learned from the recent upheaval and work is currently underway on the part of both regulators and industry covering the causes and implications of recent events and the development where necessary of regulatory responses. It is important that the work is allowed to run its course and that market solutions are evaluated and impact assessment conducted before action is taken.

  25.  A number of themes are common in these reviews—including accounting policies, valuation, disclosure, transparency, risk management, credit rating agencies and supervisory activity—and we think that these issues are worthy of careful consideration given the global market inter-relationship highlighted by recent events. International agreement on any way forward is very important.

MODIFICATIONS TO THE OPERATION OF THE FINANCIAL SERVICES COMPENSATION SCHEME'S DEPOSIT SUB-SCHEME

  26.  Minimum levels of compensation coverage are prescribed under the EU deposit guarantee and investor compensation directives. These measures are silent, however, on how compensation payments should be financed but they note that the financing arrangements "must not . . . jeopardise the stability of the financial system" of a Member State. The directives follow the home country control principle. The level of cover is established by a firm's home state, and a firm with customers in other Member States cannot be required to join the scheme in such customers' country—if such a firm becomes insolvent, the customer will be compensated only by the firm's home scheme (unless the firm has elected to benefit from additional "top-up" cover provided by a host scheme). The extent to which the home country control basis means that EU firms cannot be required to contribute to FSCS compensation payments made to UK customers should not be lost sight of when changes to FSCS financing arrangements are discussed. There are implications for the international competitiveness of the UK here.

  27.  The FSCS now provides cover in full for the first £35,000 of a person's deposits in any bank or building society; for the clients of failed investment firms, 100% cover is provided for the first £30,000, with 90% cover provided for the next £20,000 (so the maximum cover is £48,000).

  28.  The Committee notes that in addition to reviewing deposit protection limits and payout times, there are questions about whether amendments should be made to insolvency law to allow the "continuity of function" to be maintained. These matters, together with the suggestion that there might be special arrangements for "critical banking functions", are discussed in the Tripartite authorities' "Banking reform—protecting depositors" discussion paper—which, within its compensation focus, covers the ground pretty comprehensively. At this stage we, with our Members, are examining the issues that the authorities have raised, so we cannot comment definitively at this stage. However, to the extent that the FSCS is supposed to have some behavioural impact, it is clear that the level of confidence provided in September was inadequate but it is not clear what the position would have been with the more generous cover now available. It is also important to avoid arrangements that could lead to the kind of costs borne by taxpayers following the losses of US Savings and Loans depositors in 1986-95. So, in order to address moral hazard issues, in reviewing the UK scheme it will be necessary to consider arrangements that address the risk of depositors simply opting for accounts paying the highest rate of interest.

  29.  Whatever the changes to be made in the FSCS turn out to be, and assuming that there are some limits on compensation, it will clearly be important to ensure that consumers have a reasonable understanding of the ground rules.

THE MORE GENERAL QUESTIONS ABOUT THE OVERALL FUNCTIONING OF FINANCIAL MARKETS

  30.  The analysis of recent events has been covered in a number of papers. Our view, briefly stated, is that shortcomings in the US relating to certain classes of asset-backed securities led to uncertainty and loss of confidence in valuations more widely. That uncertainty, in turn, led investors to seek to unwind their positions in securities they perceived to be affected; this rational response led, in turn, to illiquid market conditions in a number of markets.

  31.  The present position is correctly summarised, in our view, by the Financial Stability Forum[9]:

    "While the disruption to the functioning of credit and money markets and potential risks for the real economy have been significant, it is worth noting that other components of the financial system have continued to function well. This is the case for the financial market infrastructure, including for the payment and settlement systems. Also, to date, the hedge fund sector per se has not been as major a factor in the systemic problems as some might have expected. Furthermore, in comparison with previous episodes of increased global risk aversion, the capital cushions of major financial institutions thus far have held up well and emerging market economies have remained largely unaffected. These encouraging aspects are signs that efforts by the private and public sector to strengthen risk management practices and resilience have been beneficial in reducing the severity of the market turmoil".

  32.  We do not think that the trend to more leveraged issuers—including the acquisition of quoted companies by private equity groups willing to take more risk with the corporate finance structure—has had particular adverse effects on the markets for financial instruments secured on other assets. The ability of investment institutions to borrow money with which to acquire financial instruments of a stated credit quality is likely to be more relevant.

  33.  Credit ratings and credit rating agencies played an important role in the growth of structured finance in recent years. Questions have been raised about the role of credit ratings and credit rating agencies in current markets, particularly in relation to the issues of (a) potential conflicts of interest in activities of rating agencies, (b) the role of credit rating agencies in the development of structured finance products and (c) the uses made by investors of ratings of these products. We note that the credit rating agencies are responding actively to these issues and are currently involved in a review of their own methodologies. These studies should be allowed to run their course; we expect that the results over the next few months will provide a valuable contribution to the mature consideration of these questions.

  34.  As part of any review on risk management, questions about the use made by investors of ratings should be considered more broadly.

  35.  We also note that the role of the rating agency is to give its opinion of the probability of default and the expected loss given default under a certain set of assumptions. It is not part of the rating agency's role, as we understand it, to give an opinion on the liquidity of the market for the security in question.

  36.  Following an extensive consultation process, on 23 December 2004 the International Organisation of Securities Commissions (IOSCO) published its Code of Conduct Fundamentals for Credit Rating Agencies (the Code), the purpose of which is to promote investor protection by safeguarding the integrity of the rating process. IOSCO said on publication that it expects all credit rating agencies to give full effect to the Code by incorporating it into their existing codes of conduct. The application of the Code by the agencies is being reviewed by the agencies in conjunction with IOSCO members. In Europe, the Committee of European Securities Regulators published a questionnaire in June 2007 on the rating of structured finance instruments as part of its second annual programme to assess the implementation of the Code by the rating agencies. The purpose of this questionnaire was to enable CESR to gather information from interested parties on the functioning of this specific segment of the rating business. CESR extended its deadline for comment to the end of September in the light of market events. If there is to be any further work on credit rating agencies, it should build on this base.

INTERNATIONAL WORK

  37.  In addition to the work being done by IOSCO and CESR referred to in paragraph 36 above we are aware of a number of initiatives:

    (a)  We note that liquidity risk management is already a subject under discussion in both Basel and the EU.[10]

    (b)  Work is underway by market participants on improving the transparency of valuation methodologies and we recognise the interest of regulators in ensuring robust and reliable valuations in a prudential context while ensuring compatibility with international financial reporting standards.

    (c)  There have been calls for increased disclosure by firms of, inter alia, their (direct or indirect) exposure to the US sub-prime market; their contingent exposures to off balance sheet vehicles and to other structured products adversely affected by recent events; and their exposure to counterparties with positions giving exposure to one or more of these things. It goes without saying that such disclosure should be managed on a consistent basis, seeking to ensure that the disclosures are broadly comparable.

    (d)  We note the fact that the Financial Stability Forum has established a special Working Group and we look forward to the further results of its deliberations.

    (e)  On 10 October 2007 the Hedge Fund Working Group published a consultation paper which puts improved disclosure to investors at the heart of best practice standards for the industry. The Report addresses issues about financial stability raised by the G8 and Financial Stability Forum as well as other concerns about the hedge fund industry. The new standards focus particularly on the areas of valuation, risk management, disclosure and fund governance. The Group has also recommended that hedge fund managers disclose more information about themselves on their websites and that more information about the industry is made available collectively to the wider public. Responses have been invited and the consultation period will run until 14 December 2007. We understand that the Group intends to issue its final report in January 2008.

  38.  The implementation in the EU of the revised Basel accord through the Capital Requirements Directive (2006/48/EC and 2006/49/EC) should also be of benefit by making capital requirements fit changing risk profiles and creating incentives to support the proper management of risk.

  39.  We are working with our colleagues in similar organisations around the world to co-ordinate the industry's response to recent events.

CONCLUSION

  40.  We strongly support the efforts underway by regulators and the industry to examine the causes of the current market turmoil and to formulate internationally agreed next steps in relation to the issues that are identified as requiring action. We continue to believe that a consistent outcome is highly desirable and that this can best be achieved through international co-operation.

  41.  It is very important that the various investigations are allowed to run their course. Market participants have a strong incentive to understand the causes of the market turmoil and develop relevant solutions for themselves. The proper regulatory process controls, including evidence based policy-making, a proportionate approach and the development of regulatory impact assessments and cost-benefit analysis, remain important.

  42.  We think there is value in avoiding hasty conclusions on possible regulatory action and regulatory actions that "crowd out" appropriate market solutions. It is important that market participants fully absorb and appreciate all the lessons that should be learnt from these events. As ever, there is a delicate balance to be struck by the authorities in taking action to improve the way the market currently works without unduly stifling future innovation.

  43.  Further, we believe that both the industry and the regulators will benefit from working closely together in reviewing both the causes of the current market turmoil and developing measures reasonably designed to reduce the probability and the impact of future events of this type.

  44.  We stand ready to contribute further to the Committee's deliberations.

November 2007






8   Directive 2001/24/EC dated 4 April 2001. Back

9   Financial Stability Forum Working Group on Market and Institutional Resilience: Preliminary Report to the G7 Finance Ministers and Central Bank Governors dated 15 October 2007. Back

10   http://www.bis.org/press/p071009.htm Back


 
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