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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